So you need a truck. Do you want to own a truck or do you want to use a truck? And how should you pay for what you want? This Buyers’ Guide helps you get to grips with financial engineering.
Around three-quarters of all truck purchases in the UK involve some sort of credit funding. Rental companies, rather than typical operators, account for the most of the remaining quarter that are outright (cash) purchases. This confirms that the vast majority of truck operators need access to credit finance of one kind or another. Quite apart from the ins and outs of the various types of finance, there are two fundamental issues. Is credit available and if so, how much will it cost? Both hinge upon your ability to repay the debt, with the overall cost likely to be lower for those deemed a lesser risk. However, some companies may struggle to find funding of any kind because the availability of finance - at any price - has decreased since the financial meltdown that started in 2008 and turned into double-dip recession.
Types of finance
Even if you are a cash-rich businesses that can afford outright purchase do not dismiss credit finance out of hand.
It preserves cash, allowing you to use it elsewhere in the business where it generates a better return, rather than tying-up money in a depreciating asset.
There are five types of finance available when purchasing a new truck, all alternatives to obtaining a loan in order to make a cash purchase:
Usually spreading the purchase cost over three years to five years, hire purchase agreements typically require a 10% deposit followed by regular payments. The payments cover the total capital cost of the truck, plus interest and fees. Ownership of the truck transfers from the supplier to you at the end of the contract, usually after a one-off fee of around £75. Some lenders may give the option of a large final payment (a “balloon payment”) in order to lower monthly payments. Only the interest element of the monthly repayments is allowable against tax.
Advantages: You own the truck at the end of the contract, giving you its residual value. Capital allowances can be claimed (see section on Allowances). If you choose a fixed rate HP deal your monthly repayments remain the same, no matter what happens to interest rates. No VAT is charged on the repayments.
Disadvantages: You normally have to pay all the VAT at the start of the contract. However, you can reclaim the VAT in the next quarter. Some HP deals provide VAT deferral, allowing you to spread the VAT cost over three months. Hire purchase is an ‘on-balance sheet’ form of finance (see below).
Contract purchase is similar to hire purchase but repayments cover the depreciation of the vehicle during the contract period, not its whole cost. Before the contract starts, the supplier sets an estimate of the truck’s residual value. At the end of the contract period you have the option of either paying a final “balloon” payment to buy the truck or simply returning it to the supplier. If you believe the truck’s actual market value is higher than the final balloon payment you may choose to pay the balloon and take ownership of the vehicle. If you believe that the residual value is lower than the balloon, you can return the truck without penalty.
Advantages: Monthly repayments are lower than with hire purchase because they do not have to cover the predicted residual value. Flexibility at the end of the contract – you can to choose to return the truck, buy it in order to continue to run it or buy it in order to sell it. This limits the risks of variable market values and gives you a guaranteed disposal route in case you no longer want the truck. Just like HP, you can claim the capital allowances. There is no VAT on the repayments.
Disadvantages: Even though the monthly payments are lower than with HP, the overall costs of contract purchase deals can be higher because you are paying for the transfer of risk (because the residual value is underwritten) and the flexibility at the end of the contract. The contract also includes an agreed distance and there are penalties for exceeding that. You pay all the VAT up front, but can reclaim it in the next quarter. Like HP, only the interest element of the monthly repayments can be offset against tax, not the whole repayment. This is an ‘on-balance sheet’ option.
Although a finance lease does not give you ownership of the truck your monthly rental repayments are structured to cover the full price of the vehicle, plus interest charges. At the end of the term you act as the leasing company’s agent and can sell the truck to a third party, keeping around 95% (typically)of the sale price. Alternatively, you can extend the agreement, continuing to run the vehicle but paying a much reduced (“peppercorn”) monthly rate.
The operator assumes the risk of the residual value. It is sometimes said that a finance lease gives you all the costs and risks of running a truck, without the ownership. The monthly rental repayments may vary to suit seasonal business patterns, helping cashflow at thinner times of the year. Because you never own the vehicle, you cannot claim capital allowances. Finance lease therefore suits businesses that have already used their allowances.
Advantages: Low initial outlay because VAT is paid monthly, not up front, and the VAT can be reclaimed. The whole of each rental repayment (not just the interest) can be offset against tax. Repayments are reduced because the finance company is claiming the tax capital allowances. Balloon payments at the contract end keep monthly payments lower on shorter leases.
Disadvantages: On-balance sheet finance. No protection from poor residual values.
An operating lease factors in the vehicle’s residual value. The lease period is usually far shorter than the truck’s life and (unlike a finance lease) the customer is paying for the depreciation in that period and the finance costs, not the whole cost of the vehicle. The lender recovers the difference by selling the truck at the end of the lease term or leasing it to someone else. VAT is paid monthly. Capital tax allowances are used by the finance company.
Advantages: Off-balance sheet finance. No VAT payable up front. The entire monthly rental fee is tax-deductible. Cheaper than a finance lease. The finance company bears the risk of the residual value.
Disadvantages: No asset at end of agreement. When residual forecast is poor, monthly payments may be costly. No capital allowances.
Contract hire may be regarded as an operating lease with a repair and maintenance contract. Other fleet management services are usually offered too, with all costs covered by a fixed monthly bill, making budgeting easy. The low-risk, all-inclusive nature of contract hire makes it attractive to risk-adverse firms or those lacking in-house transport expertise or maintenance facilities. Hire periods typically range from 12 to 60 months.
Advantages: All-inclusive fixed monthly costs. Off-balance sheet finance. Fixed interest rates. Hire periods can match a company’s operating contracts, avoiding vehicle disposal issues. No VAT payable up front. The entire monthly rental fee is tax-deductible.
Disadvantages: More costly than other options because you are buying more services and transferring most risk. Can be expensive to cancel contracts.
Key Financial Terms
Off- and on-balance sheet finance
With off-balance sheet finance options, such as operating leases and contract hire the vehicles funded do not appear on the company’s balance sheet as assets; nor are there any debts for them listed under the balance sheet’s liabilities. This means the balance sheet looks better in terms of accounting ratios such as gearing (debt to equity ratio) and return on capital. The company’s finances appear stronger, making it easier to obtain further credit or impressing potential customers who run their eyes over company accounts.
The annual percentage rate (APR) is the cost of borrowing money – the interest and all fees - expressed as a yearly rate. It is greater than the nominal annual rate of interest quoted because it takes account of the compounding of interest as each month passes. For example, for a one-year loan a nominal annual rate interest rate of 7.0% translates into an APR of 7.22%. This is because one twelfth of the nominal annual rate (0.583%) is applied to the remaining balance of the loan each month, as well as the nominal interest rate.
APR can be fixed or variable, tracking external factors such as the Bank of England base rate. Lenders must publish APR figures to allow customers to easily compare different financial products and different loan periods.
Unlike an APR rate, which is the rate charged on an outstanding debt, interest on a flat rate is charged on the original amount borrowed, irrespective of how much has been repaid. For example, a flat rate of 3.5% means you pay £35/year for each £1,000 you borrow.
The typical flat rate from truck manufacturers’ finance arms right now is around 3.2%, whereas the average compound (APR) loan from a bank or building society may be 7.4%. At these rates, APR fees for a £50,000 loan spread over five years amount to £9,971 whereas the flat rate interest payments total £8,000.
Capital allowances enable businesses to write off the costs of capital assets against their taxable income.
There are two capital allowances applicable to trucks: annual investment allowance (AIA) and writing-down allowance (WDA). The current AIA limit is £25,000, meaning you can offset £25,000 of capital expenditure made in a year against tax. Writing down allowances are available for any balance of capital expenditure not covered by AIA. The main rate of WDA is currently 18% per annum. So, if you buy a truck costing £60,000 in the current financial year, you may offset £25,000 of that against tax as this year’s AIA, carrying over the remaining £35,000 into your WDA ‘pool.’ 18% of the value in the pool (£6,300) may be offset against tax next year, leaving a balance of £28,700 in the pool to qualify for a further 18% WDA in the subsequent year.
AIA and WDA limits and your ability to utilise these allowances can affect your choice of finance options.
Availability and cost of finance
It became notoriously difficult for many small businesses – including hauliers – to find credit finance in the aftermath of the recession. Since then, the situation has eased but the picture remains patchy.
Anecdotal evidence from truck finance experts suggests there are occasions when it can still prove difficult to source credit. In his May 2012 inflation report, Bank of England governor Mervyn King says: “Credit conditions, far from easing, have in some cases become tighter. The direct and indirect exposures of UK banks to the euro-area periphery have affected funding costs.”
Figures from the Finance & Leasing Association (FLA) show that commercial vehicle finance in February 2012 was 22% up on the February 2011 figure. Willingness to lend and the level of interest rates depend upon the financial climate and the perceived risk of the individual deal. Lenders consider the merit of the application, examining the applicant’s balance sheet, current or future contracts and credit history. They also use credit reference agencies (CRA) to help assess creditworthiness.
With the base rate anchored at 0.5% ever since March 2009, typical flat rates have not changed hugely since then. For example, a typical five-year HP flat rate has come down from around 3.5% to just under 3.2%. There currently is speculation that rates will rise due to the uncertainty about the stability of the Euro.
Sources of finance
A bank loan finances a cash transaction, with the loan repayable in weekly, monthly or quarterly instalments. This model closely follows the principle of hire purchase, with an on-balance sheet debt, up front VAT and capital allowances.
Banks used to be a reliable source of loans for small and medium enterprises (SME) but that reputation has been tarnished in recent years, with companies seeking to grow their businesses complaining that banks will not back them. In 2011, Britain’s top five banks lent £215bn to businesses, 13% more than the target agreed with the chancellor. However, they fell short on lending to SME.
While many banks have specialist divisions for asset financing, sparse knowledge of trucks may make them reluctant to lend. The risk of default and the problems associated with asset disposal if things go wrong will increase the interest rates and/or shorten the loan period. And if you are considering further capital investment in the near future, such as a new warehouse, it may be worth preserving your credit line with the bank, seeking vehicle finance elsewhere.
Manufacturers’ finance arms are in the business of providing credit to finance trucks but they will not make rash decisions to drive up truck sales. Operators will still be subject to rigorous credit checks. However, vehicle manufacturers understand our industry and are well-placed to assess risk and creditworthiness. Another key factor is their ability to re-market used vehicles through franchised dealers, giving them more influence over residual values. Maximising residual values is crucial for competitive contract hire and operating lease rates.
“Interest rates offered by manufacturers do not vary greatly from rates offered by banks or specialist firms. However, because of their closeness to the market monthly repayments may be lower due to the manufacturer’s ability to take a more accurate view of residual values,” says Tom Sloan, European insurance director at Volvo Financial Services Global.
Contract hire specialists
Many contract hire firms are backed by large banks or private financial institutions. They borrow money cheaply from their parent companies and pass on the benefits to their customers. Contract hire specialists will offer short-term rental agreements (six months to two years), as well as more common three-to-five-year deals. On short-term deals customers must be prepared to accept fairly standard truck specifications but contract hire firms will more readily deviate from the standard for longer contracts.
Repair and maintenance services may come from both franchised dealers and independent repairers. Contract hire companies use their bulk-buying power to drive down workshop labour rates, giving small operators highly competitive maintenance costs once reserved for big fleets.
Richard Gosling, sales director at leasing specialist CVS, says: “The biggest advantage for taking long term contracts are fixed cost, maintenance costs and compliance. Knowing your vehicle is kept well maintained and managed to the current legislation is reassuring for operators.”
Just like interest rates, the size of the deposit depends on the financial climate and the perceived risk of the applicant. “The standard deal most operators will get is 10% on 3-4 years, but for longer periods or for those with weaker credit that may be 15% or 20%,” explains Neil Galloway, Renault Trucks Financial Services sales director. “If you’ve had a couple of bad years on the accounts, the underwriters will want more security on the vehicle to balance the risk.” The larger the initial deposit, the smaller the monthly repayments, so many operators use the residual value of one truck as the deposit for the next.
Varying Contract Length
The lender will add a penalty fee for the early settlement of finance deal typically around 1-5% of the rental rate. In the case of hire purchase, contract purchase and finance lease, agreements will give a revised residual value to be factored into the final settlement.
Most lenders accommodate a contract extension because it adds revenue and encourages future business.
Extending a contract hire deal will lead to a big hike in the maintenance costs element because these will reflect the age of the vehicle, rather than the average of the maintenance costs for the first contract period. Finance lease contracts can be extended at a greatly reduced monthly rate.
Damage & Return Conditions
Where vehicle ownership remains with the lender, such as contract hire deals, the lender wants to preserve its asset, so will expect repairs to be carried out at an accredited workshop, possibly its own. The operator must be prepared to pay for that, so it is worth clarifying repairs procedure and costs before signing the contract.
Finance companies expect their trucks returning from contract hire and operating leases to be in a reasonable condition, able to meet residual value forecasts. The ‘fair wear and tear standard’ drawn up by the BVRLA (British Vehicle Rental & Leasing Association) is a widely used guide of what is an acceptable condition. In the event of a disagreement, BVRLA operates a conciliation service.
“Wear and tear can be a concern, but contract hire companies and manufacturers are always looking to sell the next vehicle,” comments Russell Patmore, PACCAR Financial sales director. “The BVRLA guidelines are clear, and reputable companies will follow these and use an FTA-trained end-of-lease inspector.”
“We like the budgeting predictability and peace of mind that contract hire offers"
Calvin Irvine, Refrigeration Service Manager, Montgomery Refrigeration.