One of the biggest decisions that new club operators must make is whether they will lease or buy their equipment. No one answer fits every situation. Your decision will depend on the specifics of your fitness facility, your financial situation and what you need to purchase.
When I am trying to understand the financial requirements of any new project, I typically separate the funds required into three groupings:
1. The estimated cost to build out the actual space, which in some cases may be financed by the landlord.
2. The working capital (typically contributed by the owner) from start to when the company will be profitable.
3. Tangible items needed to run the business.
Club owners who are well capitalized and willing to invest their capital into the business likely will find financing to be unnecessary and an added expense. However, if the owners are thinly capitalized, securing financing is a necessity to preserve whatever capital the owners are planning to contribute into the business. Preserving working capital is a key ingredient to remaining in business and, ultimately, to becoming a successful business owner.
Equipment leasing is a common method of preserving capital, but what exactly is involved in a lease? A lease is an agreement in which the lessee, or business owner(s), agrees to pay the lessor (the leasing company or manufacturer) to have use of the equipment for a specific period of time. A lease payment is recorded on the club's books as a rental payment similar to a rent payment on a building lease. Leasing enables club owners to preserve their working capital as an alternative to purchasing the equipment since a typical lease requires a relatively small upfront deposit. Club owners profit from a lease transaction if the club generates revenue in excess of the monthly lease payment, thus generating positive cash flow from the use of the equipment. Typical lease repayment terms range from 12 months to 60 months. Consequently, items that do not have a useful life of at least 12 months, such as inventory, should not be included in a lease agreement.
A typical lease uses the fitness and non-fitness equipment being financed as the collateral. Club owners need strength equipment, cardio equipment, lockers, security systems, computer systems, software, flooring and signage to build a new fitness center and to expand their existing business. Consequently, all of these items can be included in a lease since they are required to conduct business in our industry.
The main benefits of leasing are:
1. Conserving working capital. This is unquestionably the biggest benefit of leasing. If you have significant liquid assets, leasing may not be for you, but if you have limited liquid assets, preserving cash by leasing your equipment may be the difference between success and failure.
2. Managing obsolescence. Computer hardware, computer software and cardio equipment continue to evolve and need to be replaced periodically. You may want to continually upgrade your cardio equipment as newer technology becomes available. If so, you can use the cardio equipment for the period of the lease and then return it for the latest and greatest equipment.
3. Tax benefits. When a company pays cash to purchase equipment, the business books the asset purchase at cost, estimates the useful life of the equipment and depreciates the equipment cost equally over this time period, lowering their tax liability. Alternatively, if the equipment is leased, the total of lease payments will exceed the cash price. However, since lease payments are booked as a business expense, this additional cost further lowers tax liability. This calculation should be considered when estimating the true cost of leasing compared to paying cash for the equipment purchase.
Lease Types and Conditions for Approval
There are two types of leases:
1. Finance leases. Under a finance lease, the leasing company owns the asset throughout the agreement, which is considered to be the full economic life of the asset. Often, the club operator has an option to purchase the equipment for a nominal fee or to continue leasing at the end of the contracted period. Keep in mind that since you are not the owner of the asset, you cannot sell the asset during the rental period.
2. Operating leases. An operating lease runs for less than the full economic life of the asset, and the lessee is not liable for the financing of its full value. The lessor carries the risk associated with the residual value of the asset at the end of the lease. This type of lease is often used when the asset is likely to have a resale value, for example, aircraft and vehicles. Operating leases are particularly attractive to companies that frequently update or replace equipment and want to use equipment without ownership.
The key conditions to receiving a lease approval are:
1. Cash flow. For leases in excess of $50,000, the key to receiving a lease approval is reporting positive cash flow. Most underwriting formulas add net income and depreciation (a noncash expense) to calculate free cash flow. Free cash flow must exceed the annual lease payments by some margin for the requested amount. For example, if the company reported $75,000 net income and $50,000 in depreciation, an underwriter may consider that at least $100,000 is available to pay the new lease payments. If the lease request requires annual lease payments of $50,000, the lease probably will be approved. If the lease payments require annual lease payments of $150,000, the request probably will be denied. Typically, the only documents accepted by lenders to verify cash flow are tax returns, financial statements prepared by CPAs and business bank statements.
2. Personal credit. Personal credit plays a large role in all lease approvals. A 700-plus credit score is now required from "A" lenders, and credit scores of 650-plus are typically required by "B" lenders. "A" lenders will typically approve higher amounts, and the monthly payments are less per $1,000 approved. Nearly all lease transactions are guaranteed by all company owners with more than 10 percent equity in the company.
3. Business credit. Business credit scores for companies are recorded by Dunn & Bradstreet and Paynet. I advise all club owners to check that the information reported about your company by these agencies is correct before applying for financing.
4. Collateral. Since not everyone has a 650-plus credit score, and not everyone owns a company that reports a net income and has good business credit, some people need to turn to "C" lenders. These lenders will offer leases that require additional collateral, meaning they will require that you post marketable securities, CDs or real estate as additional collateral to secure the lease.
BIO
Paul Bosley is a partner and national marketing director in First Financial, www.ffcash.net and owns www.healthclubexperts.com. His industry experience includes previous partnerships with Titan Management Co., Q The Sports Clubs and Bally HTCA/Holiday Health & Fitness Centers. Bosley has a bachelor’' degree in health science and recreation management and is pursuing a degree in accounting. He is a speaker at the Club Industry and International Health, Racquet & Sportsclub Association (IHRSA) conferences. For more information, you can contact Bosley at (800) 956-7313 or [email protected].