Businesses today rely on all different kinds of equipment to keep operations running smoothly and meet customer expectations for on-time delivery of products and services.
This is true for not only equipment-intensive businesses like manufacturers, distributors and construction firms but also some service businesses that require the latest new computers and software to meet client demands.
One of the biggest mistakes these businesses sometimes make is failing to plan ahead for replacement of such equipment. Neglecting to budget for replacement capital expenditures, or capex, can result in serious financial strains when the time eventually comes to upgrade critical business equipment.
Pay Now … or Later
Budgeting for replacement capex is kind of like the old commercial for Fram oil filters in which the auto mechanic says, “You can pay me now … or pay me later.”
The question isn’t whether or not equipment is eventually going to wear out or become obsolete and need replacing. It will. The question is how are you going to pay for new equipment when the time comes?
If you don’t plan ahead and budget for replacement capex and you don’t have enough liquid funds to pay for new equipment when the time comes, you must lease or finance the equipment. You will determine the amount of free cash flow after servicing existing debt to see how much financing you may qualify for.
And remember: You may or may not qualify for the financing needed to replace or upgrade all the equipment that needs it.
It’s important to note that leasing or financing equipment isn’t necessarily a bad thing —in some instances, it’s preferable to paying cash. But failing to plan ahead and budget for replacement capex severely limits your options when it comes to acquiring new equipment in the future.
Build a Reserve Fund
One strategy is to build a reserve or sinking fund for replacement capex. This fund should be equal to your annual depreciation expense, at a minimum. Here’s an example of how this might work for a construction company with a fleet of 10 cement mixing trucks:
The owner of the business plans on replacing two trucks every year at a cost of $150,000 per truck, or $300,000 total. To ensure that there is sufficient cash on hand to buy the trucks a year from now, the business would need to set aside $25,000 per month in reserve for the next 12 months.
If the business continues to save this every month in a sinking fund, it will be able to replace its two oldest trucks every year debt-free. As a result, no truck in its fleet will ever be more than five years old. This will help the business save money on repair and maintenance costs while minimizing downtime and keeping its fleet up to date from a technology perspective.
This strategy will give the business a tremendous amount of financial flexibility when it comes time to replace aging and obsolete trucks. For example, it can buy the trucks outright in cash or use the reserve funds to put a substantial down payment on the trucks and finance the remainder. This would help ease demands on monthly working capital and improve cash flow.
A Critical Exercise
Capex budgeting is a critical exercise for any company that uses equipment in the normal course of business. If you haven’t budgeted for replacement capex in the past, resolve to do so starting now.