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Equipment Executive: New Thinking for a Changed Economy

Financial realities constrain machine-replacement options, but there is a way out

January 01, 2011

Everybody has been downsizing and holding on to their old iron. Business conditions have been brutal and it certainly has not been fun bidding work, winning work and building work in an industry that seems to have lost sight of the balance between risk and reward.

More and more folk are talking about an upswing. It will surely come, and we need to know what to do when volumes start nosing up and margins, eventually, get back into line. Unfortunately, the upswing will not be an easy time for equipment managers. The capex flood gates are not going to open, and it is not going to be possible to replace the old iron as fast as job demands will dictate.

The reason is simple. Most company balance sheets have taken a pounding over the last while; few are flush with cash, and most are as highly leveraged as they would like to be. New jobs will call for working capital to finance receivables, retention and inventory, and an upswing will stress test already stressed balance sheets. Cash for working capital will come first; cash for equipment purchases will come second. The old fleet will have to serve you a little longer, and we will all have to learn how to make good decisions in what will most certainly be a changed economy.

Let’s look at traditional fleet-replacement options, understand the new constraints, and develop strategies necessary to keep our fleet effective and productive in a world that will be much more financially aware and risk averse than it has ever been.

“Buy” reduces working capital
By this we mean using our own money—cash—to buy a machine, keep the fleet average age at or around the sweet spot, and minimize lifecycle owning and operating cost. It is the “right” thing to do and, depending on how you measure the cost of the money you have tied up in your fleet, likely to be the lowest-cost solution.

So why not do it and keep on doing it? Because using up cash assets by investing in equipment assets dramatically reduces available working capital. Accountants, bankers and bonding companies like to see sufficient working capital to meet current liabilities, so there is a limit to how much of your fleet replacement you can do by simply buying it.

“Borrow” increases debt:equity ratio
If we cannot use our own money, borrow funds to finance all or part of the purchase. This is routinely done, and it is a good way to augment available funds. It is a lot riskier and can be more expensive as both the interest and the repayment of the amount borrowed are fixed in terms of the loan agreement. Clearly your company cannot take on too much debt and clearly there are limits to the amount of borrowed money you can use to replace your fleet.

The finance community gives guidance, and sets limits on the use of debt, by defining acceptable levels for the debt-to-equity ratio in a business. Chances are your company is carrying debt to finance land, buildings and other assets. Chances are the debt available to finance equipment purchases is limited.

“Lease” increases commitments
 If equity or debt are not available to finance equipment purchases, consider lease agreements. Leases are complicated financial instruments; they give you the right to use the machine in exchange for a fixed commitment to make pre-agreed future payments. Leases are not subject to many of the balance sheet constraints we have discussed, but the days of unlimited, hidden and unscrutinized lease commitments are over.

From a practical day-to-day working point of view, the main risk associated with a lease agreement is the fact that it represents a firm, fixed commitment stretching many years into the future. Increasing fixed costs in a volatile economy is a risky choice, making leasing a limited option.

“Rent” reduces core capacity
Rent is the fourth side of the financial realities box. If the other three don’t make immediate sense, why not rent and get the right to use the machine in exchange for a short-term agreement to pay? That could be fairly expensive as you are asking the rental house to carry a lot of risk on your behalf. More importantly, owners and bonding agencies do not like to see the majority of your core productive capacity being subject to short-term agreements. It is fine for compactors and skid steers where there is a good rental market, and it is fine for specialized lifting equipment that will be used for a specific task, but it is difficult to imagine acquiring the core fleet that will carry your business into the future through a series of short-term rental agreements.

“Run-and-repair” offers an alternative
In fact, there is no easy way out of the financial realities box. Construction is a capital-intensive business. When capital is expensive, in short supply, or needed elsewhere, then run-and-repair may be the only alternative. It is an alternative many equipment managers do not like as it often means we must exceed economic life of our equipment and change our established norms. But it is, and will continue to be, a changed economy. It may, indeed, be time for us to change and look at run-and-repair as an alternative to replace.

Run-and-repair is the tough alternative. The toughest part is that it requires managers at all levels across the organization to change their attitude, style and perspective toward equipment:
• Operations must know that the object of the exercise is to conserve the equipment investment through proper operation and application. Styles and attitudes that lead to the destruction of that investment through over-application and abuse cannot be tolerated.
• Accounting and budgeting must accept that the older fleet will be more expensive to operate. Budgets and budgeting norms must be changed and cost control improved to manage the high levels of parts and labor spending needed to keep an older fleet up and running.
• The equipment group must sharpen its ability to inspect, maintain and prevent failure. Services and inspections must be done when due and to the highest possible standards. Fuel and oil must be stored and dispensed with the highest levels of cleanliness possible. We will be working with older machines; mechanics and field technicians must be better custodians of their health.

The organization must still use all four traditional acquisition options to assemble a portfolio of equipment investments that respect the new financial realities. But run-and-repair is an option when the box starts to close in. It can be successful if managers communicate it, understand it, and support it across the company as a whole.

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