When to Finance or Pay Cash for Business Purchases
We are currently in the highest interest rate environment we have been in years. The federal funds rate was at a low of 0.25% in 2008 and was raised to over 5% in May 2023. As a business owner facing a large expense, you want to make a wise decision regarding when to finance or pay cash. Keep reading to discover the benefits of financing vs paying cash, depending on the economic environment and your unique situation.
Understanding When to Finance or Pay Cash Based on the Economic Environment
The Federal Reserve is raising interest rates to combat high inflation. By raising interest rates, companies and individuals will be less likely to borrow (since it’s more expensive) and will forego spending. A slowdown in spending will result in less demand for goods and services, and the lower demand will create slowdowns in inflation.
However, as a business owner, you may still have purchases you need to make. Therefore, the key decision now is whether to finance your projects or just pay with cash. There are factors to consider beyond what I mention in this article, including your current debt load; but for now, I will assume a scenario where you have minimal debt.
Capitalizing on the Benefits of Paying Cash vs Financing
When deciding when to finance or pay cash, you must first understand if you are truly in a position to pay with cash. Just because you have $500k in the bank account does not mean you can go out and buy a $400k piece of equipment. (Well, you can, but I strongly advise against it without considering other factors first).
So, how do you know if you’re in a position to capitalize on the benefits of paying cash? Ask yourself these two vital questions:
Are You Currently Liquid?
You can’t pay for things you typically financed in the past with cash on hand now unless you are liquid. What do I mean by this? A measure of liquidity is your current ratio. It is current assets (Cash, AR, Inventory, Prepaid Expenses) divided by current liabilities (all bills due within 365 days, including any amounts due on long-term debt).
You are not liquid if your current ratio is upside down (less than 1). This ultimately means you don’t have enough liquid assets to pay for outstanding debts. This is a real problem. I like to see most companies hover at least at 1.5. But, you should ultimately benchmark yourself against industry peers. Every industry has different requirements, and if you are well below the industry average, you are not in a position to start paying for things with cash.
Are you unsure of your industry requirements and peer ratios? Brady CFO offers a risk-free Financial Clarity Assessment that provides you with an inside look at how you measure up to your competition with clear industry benchmarks to understand peer performance and what’s possible for your business. Learn more about our unique Financial Clarity Assessment.
Do You Need Cash to Pay Yourself a Distribution/Divided Later On?
Owners of private companies often need to pay themselves dividends to cover personal expenses. However, distributions are never recorded on an income statement, so most don’t budget for these appropriately. But, you need to ensure you have enough cash to cover your own distributions before you consider using that cash to finance an equipment purchase, for example.
It’s better to finance something that can act as collateral (equipment) than to pay cash for equipment and try to finance your distribution (no collateral). The way to determine if you have enough cash to pay yourself appropriate distributions is to have a cash flow forecast. Learn how Brady CFO can help you build one.
Paying Cash vs Financing: Summary
With a cash flow forecast in hand, you can determine if you project to have enough cash to pay yourself a distribution. But, if your forecast reveals you barely have enough funds to pay the distribution and you have liquidity concerns, your best bet is to finance your purchases for now.
You should consider different financing terms via your cash flow forecast and make the best decision by examining conservative business growth and operations scenarios. This is the best way to make sure you don’t over-leverage yourself.
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So, Is It Better to Finance or Pay Cash?
If you determine that you are liquid and have excess cash after accounting for distributions/dividends to yourself, you now have a decision: when to finance or pay cash? Again, there are two questions to consider:
Can You Generate a Higher ROI than Your Interest Rate?
You need to consider whether or not you can deploy the amounts you receive from financing to obtain a return greater than the interest rate you are paying. If your loan is charging 8% interest, the question is whether or not you think that by making that purchase, you can achieve a higher rate of return than 8%. And keep in mind that it’s not about producing 9% or more sales. It’s about your bottom line.
By paying the bank 8%, can you create more cash from new revenue and/or reduction of expenses that is greater than 8%? If so, the benefits of financing apply, and you should consider deploying your cash in other ways. However, if you don't feel comfortable that you can produce this level of return, you should pay in cash–but don’t spend so much that you make yourself illiquid or risk paying yourself your needed distribution.
Is Business Slowing Down?
The other major consideration is whether you feel your business environment is slowing down. If so, it is often better to keep cash reserves on hand. If you have cash on hand, it’s easier to get financing when you need it rather than to enter a recession, not have enough cash, and try to obtain financing. Banks may not be willing to work with you, given your economic outlook. So, it’s often best to consider keeping cash on hand and maintaining a liquid balance sheet for a rainy day.
Get a Personalized CFO Perspective on Your Finances from Brady CFO
Would you benefit from a CFO’s perspective on your financial situation to help you determine when to finance or pay cash in this economic environment? With Brady CFO, you can receive a risk-free Financial Clarity Assessment to help you make the best decision for your small business. Schedule a free consultation today!