Equipment financing 101: Everything you need to know
Equipment or machinery financing is a type of business loan enabling your company to get funds for buying or leasing tangible long-term assets that can benefit your business over several years of use, such as machinery, hardware, vehicles or equipment.
Investing in equipment is a great way to replace manual work, boost productivity and cut costs.
After having helped hundreds of businesses obtain financing, Concetta Farina, Account Manager, Virtual Business Centre, BDC, says that one of the most common questions she gets is: “Why should I borrow?”
“Financing a piece of equipment out of your everyday cash can put your business at risk is my answer,” she says. “Let’s say you are buying a piece of equipment that has a life span of a seven years. You’ve just tied up your money in this asset and you risk missing out on other business opportunities,” she adds.
Whether it’s an automated line, trucks, computers or specialized equipment, such as CNC machines, the right equipment can put your business on an accelerated growth trajectory.
Concetta Farina
Account Manager, Virtual Business Centre, BDC
What can I finance with an equipment loan?
Here are some of the things you can finance with an equipment loan:
- Production line machinery
- Automated equipment
- Robotics systems
- Hardware
- Specialized equipment (lab material)
- Commercial vehicles (trucks, trailers, specialized transport equipment)
- Renewable energy and waste management equipment
How does equipment financing work?
Farina gives the example of a pizza restaurant owner who decides to buy a modern, new oven.
“According to the entrepreneur’s research and calculations, this new piece of equipment will increase production capacity by 20% while generating recurring savings on the restaurant’s electricity bill. This is a good investment,” explains Farina.
When asking for the loan, you will typically be requested to provide a quote for the equipment that you want to buy, though loans can also cover previously purchased equipment.
Most of the time, the equipment is used as collateral for the loan, and the loan repayment duration is aligned with its lifespan.
For bigger amounts, a cash downpayment might be required. The amount depends on the lender and your business’s financial situation.
Most common types of equipment financing
Each equipment financing option has advantages and disadvantages, so do your homework to find the best option for your business.
1. Vendor financing
The seller of the equipment can finance the purchase through vendor financing. Many manufacturers have their own financing divisions that offer discounts to stimulate sales at dealerships. Other equipment sellers without in-house financing options have partnerships with other financial institutions to help get a lease or a loan.
Opting for vendor financing has the advantage of being fast, convenient and having lower upfront costs. However, Farina cautions entrepreneurs to do their due diligence. “This is a shorter-term loan with less flexibility than more traditional term loans,” says Farina.
2. Equipment loan
An equipment loan is a specialized term loan used to finance equipment acquisitions. It is usually secured by the equipment being bought, meaning that the lender can seize it if you don’t make your payments.
This is a more flexible option than vendor financing. With an equipment loan, you can get extra cash to cover any additional costs associated with the equipment purchase. “For example, BDC can finance up to 125% of the upfront cost of the equipment to cover extra expenses like transportation, shipping, installation and training,” says Farina.
Some banks, including BDC, also offer principal postponements for up to the first two years on equipment loans.
For expensive, large equipment acquisitions, a mix of different types of financing can be used.
3. Working capital loan
A working capital loan (or a cash flow loan) is a short-term business loan to finance your day-to-day operations. “It’s a multi-purpose loan that can be used to finance a variety of things, from inventory to marketing, salaries and smaller, less expensive pieces of equipment,” says Farina. “It’s an injection of cash. It will give you the liquidity you need.”
Cash flow loans usually have shorter amortization schedules (around 6-7 years), while equipment loans can be repayable for up to 12 years.
4. Line of credit
A line of credit is a short-term, flexible loan that you can use to borrow up to a pre-set amount of money, paying interest only on the amount that was borrowed. Often secured by inventory and accounts receivable, lines of credit are considered “demand” loans, meaning the financial institution can demand full repayment at any time.
Farina doesn’t recommend using your line of credit for equipment purchases—unless it’s for small, inexpensive equipment. “The rule of thumb is to use term loans for expensive equipment with longer lifespan to protect your company’s liquidity.”
Two examples of equipment loans
Example 1: A simple equipment loan
ABC Inc. is applying for a $90,000 equipment loan to purchase a new, modern pizza oven.
The loan would be amortized over five years. The principal payment amounts to $1,500. Assuming an 8% interest rate on blended payments, the total monthly payments, including interest, would amount to $1,825.
$90,000 % (60 months) = $1,825 average monthly payment
You can calculate the hypothetical weekly payments on a loan using our free, online business loan calculator.
Example 2: A more complex equipment loan using different types of financing
XYZ Inc. is applying for a $350,000 loan to buy an automated packaging line.
- Total loan amount: $350,000 ($300,000 for the equipment + $50,000 for training and setting up the equipment)
- Traditional financing: $245,000 (70% of the loan)
- Vendor financing: $70,000 (20% of the loan)
- Cash down payment: $35,000 (10% of the loan)
| Traditional financing | Vendor financing | |
|---|---|---|
| Amount | $245,000 | $70,000 |
| Interest rate | 10.55%* | 9%* |
| Term | 8 years The monthly payment for this loan is $4,706 ($2,552 principal + $2,154 interest). |
5 years The monthly payment for this loan is $1,691 ($1,166 principal + $525 interest). |
| Monthly payment | $4,706 | $1,691 |
| Total monthly payment | $6,397 |
* Many factors can affect interest rates. While pricing is unique to each financing request, generally, interest rate on vendor financing will not exceed the rate applied to traditional financing.
What documents do I need to apply for equipment financing
Most financial institutions will ask for the following documents:
- Company details: Information about your company’s history, current operations, strategy and management team experience.
- Financial statements: Banks typically review financial statements to understand a company’s financial health, profitability and capacity to repay debt. For larger loans, statements are needed for the past two years along with interim statements comparing the latest period with the same period in the previous year.
- Financial projections: Banks typically require a monthly cash flow forecast for the remainder of the current year and the following 12 months. In some cases, two years of projections may be requested.
- How you’ll use the loan: “Bankers need numbers,” says Farina. Prepare details about the projected sales increase, plans for using the financing and exactly how it will help your business. “You will need to provide an explanation of how the equipment will increase your sales or how it will improve your profitability or efficiency,” she adds.
Pro tip: Keep an eye on your debt-to-equity ratio
When asking for a new loan, you should ensure you have a healthy debt-to-equity ratio and sufficient working capital. Your debt-to-equity ratio measures how much debt your business is carrying compared to the amount invested by its owners and the earnings that have been retained over time.
Bankers closely watch the debt-to-equity ratio. The higher it is, the more debt the company is carrying. At the same time, a low ratio is not necessarily a good sign. It could be a sign that the company is too prudent and that resource allocation is not optimal.
Although it varies by industry, a debt-to-equity ratio between 2 and 3 is generally considered good.
You can measure your debt-to-equity ratio using our online calculator.
Buy or lease?
When it comes to buying or leasing, Farina says that it depends on your business needs and objectives.
If you need equipment with a shorter lifespan or equipment that needs to be updated regularly, such as computer hardware, it might make more sense to lease. Also, some leases have the end-of-lease purchase option, meaning that at the end of the lease, the vendor gives you the option to simply lease upgraded equipment under a new lease agreement.
However, if you plan on buying equipment that has a long lifespan, purchasing the equipment with a loan might be a better option.
3 things to keep in mind when shopping for an equipment loan
1. Don’t forget about additional costs
Buying equipment comes with additional costs, such as transportation, installation, maintenance, training, downtime and losses due to malfunction.
Farina says that a good rule of thumb is to always plan for additional costs of 25-30% of the equipment value. “These extras could really add up, so you need to plan for them. In many instances, you will have to train someone internally on how to use and maintain the equipment.”
2. Think about the long-term use of the equipment
Another common mistake is overlooking how to properly assess your equipment needs over time. “The equipment should fill your business needs today, and in the future,” says Farina.
- How will the new equipment accommodate future growth?
- How often will I need to upgrade it or change it?
- Does it fit within my business projections?
3. Shop around
Prepare ahead of time and—especially if purchasing a large, expensive piece of equipment—make sure you shop around and don’t rush into a transaction.
Inquire about flexible repayments and make sure that the terms and conditions of the loan won’t change without due cause. For example, you might want to ask for seasonal repayment. This would allow you to reduce your payments during the low season and increase payments when you are bringing in more business.
“Don’t focus only on interest rates,” says Farina. “Consider factors like the percentage of your purchase that different institutions will finance, the repayment schedule and the collateral you are willing to offer.”
Next step
Discover how to plan and execute successful industrial automation projects in your business by downloading our free guide for entrepreneurs, Harnessing the Power of Industrial Automation and Robotics.