Challenged with Machinery Funding…Five best opportunities for SME’s to leverage

Nothing underlines the importance of having high-quality machines in your manufacturing set-up as Clive James’s famous quote, “It is only when they go wrong that machines remind you how powerful they are.”
For a manufacturing company, machinery is to business what a heart is to a human body.

For illustration, let us take an example. Let’s say you are in the business of printing. Given the developments in the industry on techniques & technologies, ask for an upgrade of your machinery. If you do not take the leap, your offerings will narrow down as you will not be able to offer the new ask from the customer, and quality will suffer as older machines may not match the output of the new upgraded ones leaving you with a loss in customers and most likely your reputation. Hence, investing in machinery may be the optimum choice.

The challenge is an investment in machinery requires funds. How does one get the funding?

Business machinery can cost hundreds or thousands, or millions of dollars. It is one of the most significant investments for a company. While MNCs may find it easy to raise funds for machinery purchases, for Small and Medium Enterprises (SMEs), it is a Herculean task.

The limited pocket depth and the need to stretch one’s runway pose a challenge for SMEs when considering an investment in machinery.

If they consider debt funding, they battle with break-even and return on machinery investment.

Thus, a business must make an informed decision when evaluating funding options for machinery. Let us look at five options that offer efficient machinery funding options.

Vanilla Term Loan- A traditional method of raising funds provided by commercial banks. Opting for this type of funding requires collateral, but the process is straightforward. Vanilla Term Loan will extend you a loan up to around 70% to 75% of the total machine cost, including GST+ custom duty (if any).

It has a long turnaround period as it is a traditional fundraising tool, but the competitive interest rates make it a tool of choice.

Equipment Finance- NBFCs extend this loan. The criterion for this loan is the machinery standard, the borrowing SME’s credit rating and industry reputation.

The loan extended here is around 70% to 85% of the machine’s value. Terms and approvals hinge on the credit structure of the company and the machinery being purchased.

The benefit this funding tool brings is it does not require collaterals, and they extend a higher funding amount. The flip side is that the cost of funding is a little higher.

Buyer’s Credit- Machinery funding choice for SMEs importing machines and are involved in the export business for natural hedge. SMEs can avail the buyer’s credit from banks or through NBFCs (with the help of banking lines) for their imported machines.

Buyer’s credit route reduces the cost of funding. If asset funding is through NBFC, it saves the company on collateral pledging.

However, if the export numbers over the years have been uncertain and the forex wind is unfavourable, foreign funding can prove to be costlier than domestic funding. Thus, SMEs should consider all aspects and consult a fundraising expert before opting for this tool.

Supplier’s Credit- This facility is provided by the statutory bodies of foreign companies that promote local companies to expand their business. The statutory body creates a fund allowing its local counterparts to offer supplier credit to the purchaser. While SMEs get funding for machinery, foreign companies also benefit from the increased sale.

In this method, SMEs buy machinery from a foreign company that supports local companies via supplier credit to buyers. This method also does not require any collateral and reduces the overall cost. The downside of this method is that SMEs must abide by the laws and eligibility criteria of the country of the foreign company.

Leasing- Out of all the methods discussed, this is the most innovative. Machinery leasing is similar to leasing land or a house. Here, a lessor buys a machine and rents it to a business. As this is not a debt but a lease, there is no impact on the leverage structure on an SME’s balance sheet.

The biggest win here is that the Lessee can purchase the machine at the end of the lease tenure at the depreciated value.

The typical tenure for a machinery lease is between two to seven years. Thus, SMEs also gain the flexibility to change or replace their machinery with upgraded ones without a hassle.

SMEs are free from the requirement to bear the cost of GST on machinery acquisition as it is on the lessor’s balance sheet, creating a direct and positive impact on the margin required to buy the machinery.

The leasing method extends funding up to 80-85%, allowing businesses to focus on core areas and maintain a healthy bottom line. This method removes the need for collateral pledging and approvals from the existing debt holders or bankers since leasing is not a loan. As a result, it has a short turnaround time.

Machinery Leasing in India is still at a nascent stage. Limited awareness and knowledge of the terms and how to pursue leasing have impacted the adoption of this tool. Hiring an expert to look after the entire process and ensure favourable leasing terms may be a good move.

Which Fundraising Method is the right choice?

Well, no one size fits all. The size of your company, the nature of your business, growth and performance aspects, etc., all have a bearing on the funding choice for machinery purchase.

While all the above methods are viable, each has its baggage of pros and cons in terms of collateral requirements, interest rates, eligibility criteria, turnaround time etc.

Given the options discussed above, to my mind, leasing by far takes the lead with the number of advantages it brings with no impact on the company’s debt structure.

Having said that, before you seek funding for machinery purchases, get an expert on board to help identify the best option for your business.