How Wrong Can You Be? (Pt II)

In the first of this series of articles, How Wrong Can You Be (Pt I), I set out the four key principles that should direct a business's fleet funding policy; Risk, Affordability, Cash-Flow and Accounting/Taxation.

The concept of Risk was explained in more detail in the first article.

Essentially, Risk involves deciding, in relation to vehicle residual values, how big your appetite for Risk is relative to your willingness to pay for someone else to take on that Risk for you. In essence, the bigger your capability for handling Risk, the less you will want to pay someone else to take it away, and vice versa.

Now, in Pt II of the series, I'm going to look at Affordability and Cash-Flow, both concepts that are much misunderstood in relation to fleet funding.

And the reason why I'm covering both Affordability and Cash-Flow in this article is that they go hand-in-hand. If you're comparing the Affordability of different funding methods then Cash-Flow is the tool by which you measure the cost of each finance approach to get a meaningful comparison between them.

And that's also why I'm going to explain more about Cash-Flow before discussing Affordability; if you're not familiar with the principles of Cash-Flow analysis you need to understand the tool of measurement before you try measuring.

Cash-Flow Analysis

The concept of Cash-Flow analysis has been around for a long time - over 100 years in terms of accounting practice (though the early examples in the 1920s were few and far between).

Cash-Flow analysis really came to prominence in the 1980s, fuelled by the expansion of commercial financial services, the take-over boom and the advent of business desktop computers and spreadsheet software capable of performing streams of repetitive Cash-Flow calculations on business revenue forecasts, a task which became known as 'running the numbers' in the parlance of management consultants and take-over gurus.

So how does Cash-Flow analysis work?

Well, in simple terms, Cash-Flow analysis recognises a very simple principle of cash management; by-and-large, money spent tomorrow is cheaper than money spent today.

How so?

Well, sticking with fleet funding, it's because paying out money today on a vehicle deprives you of cash which could be invested in business assets that could, in turn, earn money for your company, such as a new manufacturing machine or even a savings or investment product.

The earnings generated by your investment can then be offset against the cost of financing a vehicle, reducing the real cost of vehicle finance.

Let's look at a simple example:

If you have ￡24,000 in the bank and want to buy a car today for ￡24,000, the car will cost you ￡24,000 today.

Let's say, though, that instead of buying today from your own money you finance the car on a 0% finance deal for 1 year. You then spend the ￡24,000 on a new widget making machine for your business which makes profits of ￡2,400 for you over the year.

This means that, notionally, the cost of the car would not be ￡24,000, it would be ￡24,000 minus the profits generated by the return from your widget making machine.

So, taking account of the return on your investment, in very simple terms, after 1 year the car costs you not ￡24,000, but ￡22,600 (￡24,000 purchase price less the ￡2,400 investment return).

Now think of this ￡2,400 investment return as 10%pa (￡2,400/￡24,000) off the monthly payments you made on the car over the year. Assuming 12 equal payments of ￡2,000 per month, the cost of each of the monthly cash-outflows for making the finance repayments over the year can be discounted by a proportion of the 10%p.a. return you are generating on your investment during the year.

For example, you make the first payment at the end of the first month, so you will have earned one month's investment return on it by the time the payment is made, 2 months' return on the second payment and so on through out the year.

This means the first monthly payment can be discounted for 1 month's return at 10%pa, e.g. 0.833%pa (10%pa / 12), the second payment for 2 month's return, 1.666% (2 x 0.833%) and so on until the last month's payment is discounted for 12 months' return on your investment.

So, in round numbers, after adjustment for the investment return, the first payment costs you ￡2,200. That's ￡2,400 less 1/12th of 10% of ￡24,000, which is ￡200.

The second payment costs you ￡2,000 (that's ￡2,400 less 2/12ths of 10% of ￡24,000 = ￡400) and so on.

It is from this concept of discounting future payments that the term 'discounted cash-flow analysis' is derived, to describe the process of measuring the impact of investment return on cash-outflows and comparing the cost of payment now with payment in the future.

Now obviously this example is simplistic - it assumes there's no interest charged in the finance agreement, ignores compounding of the investment return during the year, disregards any discount you might negotiate for paying cash now and any tax you might pay on the investment return.

However, it does serve to demonstrate the principle - if your investment return is high enough then money spent tomorrow is cheaper than money spent today.

And in the last part of that last sentence is the key to putting cash-flow analysis to work on your vehicle funding; it's also where Affordability comes into the equation.

Affordability

Affordability in the context of this series of articles is not about whether you can afford the monthly payments to finance a vehicle but whether you can afford to use your own money.

This is because, if you earn more on cash invested in your business than a lender charges you to borrow, there's an advantage to using someone else's money to fund your fleet.

Conversely, if you can't cover your cost of borrowing with earnings, then borrowing to fund your fleet will cost you more in real terms than using your own money to do it, and who can afford that?

So, how do you evaluate whether or not you can afford to fund your own fleet? Well, although the answer is simple, the implementation is not.

The answer is our old friend measurement. First you measure the total cost of funding for a vehicle (or, preferably, a whole fleet) via each funding option that's open to you. Next you bring our other friend Risk management into the measurement as well.

You do this by comparing the fixed costs of each type of funding (purchase price, deposit/initial and monthly finance payments, tax disc, etc), then applying cash-flow analysis to the fixed costs and repeating the analyses using variations in the floating parameters of investment return and residual value.

In other words, you do the cash-flow analysis once using a particular residual value and investment return, then repeat it using a variation, say with an investment return 1% lower, then repeat it again 2% lower, then 3% and so on.

Next you reverse the trend, and increase the investment return. Between all these re-runs you should be looking to find the point where the real cost of buying outright from cash reserves is the same as that from borrowing - that's your break-even return on investment, indicating the investment rate you must achieve to stop external funding being a financial burden on your business.

If your business can consistently achieve more than the break-even rate of investment return then external finance will, in effect, pay for itself through additional profits in the business.

If you can't reach the break-even rate then external finance is going to cost you money, so you will need to have another compelling reason if you are going to use someone else's money to fund your fleet.

But that's not the end of the story (I did warn you that implementation isn't simple).

Once you've done the analyses with varying rates of investment return it's time to do it again.

This time you need to repeat the exercise varying the residual value. This is now measuring your exposure to Risk.

In other words, you are identifying the potential impact of fluctuations in residual values (your Risk) on the rate of return you need to achieve in your business in order to keep buying outright viable in comparison to using fixed residual finance products (such as balloon leasing and contract hire, which are typically a more expensive form of finance - for an explanation of why click on this link).

Broadly speaking, the lower the rate of investment return in your business, the less resilient you will be to downward movements in residual values and the less attractive will be floating residual finance products (such as finance leasing), and vice versa.

Don't worry about understanding right now what fixed and floating residual finance products are - we'll cover these in a later article.

Now, balanced against the above concepts is the principle that lower rates of investment return also make any external funding look less attractive, so now you may be looking at a funding option with lower monthly payments and a fixed residual (contract purchase or contract hire).

If your head has started spinning with the thought of all this analytical work and the implications for your business and fleet then, as with evaluating Risk, you don't need to worry about doing the mathematics; tools are available to do this for you.

You just need to understand that you can get to a mathematical model of how affordable (or otherwise) each funding option is to your business. And once you've done that your ready for the next step!

In Part III of this article we'll look at the impact of Accounting and Taxation on fleet funding, including how to match funding to your balance sheet requirements and how to optimise the business tax reliefs and deductions available, including Corporation Tax and VAT.

In Part IV we'll show you how to bring all the fleet finance selection criteria together to formulate your strategy for vehicle funding and how to apply that strategy to selecting the right vehicle finance product(s) for your business.

#companycars #companyvans #carfinance #fleetfinance #cashflow