Published in the June 2007 Australia’s Mining Monthly

As money piles up from all the work mining contractors are doing and pressure rises to add more equipment it can be tempting to consider funding any further acquisitions through cash flow.

However, financial experts caution that this can be a very bad course of action because it can eat into working capital and actually cost the business more than taking on debt finance.

Another consideration is which institution a contractor has a financing relationship with. It can sometimes pay to shop around to find the best deal rather than just going to the bank it has traditionally dealt with.

However, sometimes finance decisions can take a back seat when the opportunity cost of not purchasing a piece of equipment is weighed up.

When it comes to funding equipment acquisitions, most contractors seem to be choosing finance leasing or hire purchase. Some are opting for an operating lease but those are in the minority.

That could be because finance leases seem to be a more transparent instrument.

A finance lease involves a lender funding 100% of an asset over a term – usually two to eight years – with rentals calculated to pay that debt down to a residual value that should roughly match the estimated future market value of the equipment.

This residual value is fully disclosed and indemnified by the borrower. At the end of the term the borrower buys the equipment for the specified residual fee.

If the borrower does not purchase the equipment then the lender can opt to sell it, although the borrower will be responsible for any shortfall.

An operating lease also involves a lender funding 100% of an asset over a term – usually two to eight years – with rentals calculated to pay that debt down to a residual value.

However, that residual value is usually less than the estimated future market value of the equipment and is not usually disclosed. It is also not indemnified by the borrower. In essence the lender or a third party such as a residual value insurer carries the residual value risk with an aim to make a profit on resale or re-rental upon expiry of the lease term.

So-called “return conditions” apply to ensure the equipment is adequately maintained and returned in an acceptable condition. There are also often additional charges for excessive use of the asset beyond the level agreed upfront.

At the end of the finance term the borrower must return the equipment to the lender and pay any costs pertaining to the return conditions. Alternatively the borrower can negotiate to purchase the equipment or re-rent it.

The lender carries the risk of the realisable value of the asset falling below the residual value taken.

Another big difference between finance leases and operating leases is that finance leases are referred to as “on balance sheet finance” because the full financial liability is shown in the financial statements while operating leases are considered to be a form of “off balance sheet” funding.

Australian Structured Finance Group managing director John Dennis is a firm advocate of contractors weighing up their finance options rather than buying equipment out of existing cash. He said debt reflected a more efficient use of financial resources for a company.

“Long-term debt is used to acquire long-term fixed assets or investments leaving cash flow to be applied to meeting operating expenses,” Dennis said.

He said finance leasing was more transparent and usually preferable.

“You wouldn’t really use an operating lease unless there’s a driver to take your equipment off balance sheet,” Dennis said.

With a finance lease it can be worth the borrower’s while to opt to purchase the equipment too.

“They are often better placed to dispose of the equipment. If there is a scarcity of equipment you can keep control of it.”

Finance and operating leases aside, financiers are starting to create their own products for the contract mining industry.

GE Commercial Finance equipment finance managing director Kerri Thompson said GE had an equipment loan product that it had been offering for the past 12 months. “It’s a product lease facility where the lender can keep some cash to offset interest,” she said.

GE leader of business in Queensland Mark Dewer said the product helped customers manage their fleets.

“We may have cycles where a contractor may have half a dozen contracts with various amounts of equipment on each site,” he said. “Some of those assets may become surplus to those contracts. They have the ability to sell some of that equipment. It gives them flexibility.”

Dewer said there were no break costs if the contractor opted to sell some of the equipment.

Thompson said besides the equipment loan GE could do finance leases, operating leases and commercial hire purchase.

One benefit GE has in the equipment finance game is its Asset Management Group, which values equipment. Thompson said the group could estimate the value of equipment in five years time.

“They have a lot of knowledge about what’s going on in the industry and can provide accurate long-term valuations,” she said. “They have a lot of global experience and can sell equipment overseas.”

GE has a fairly healthy link with the contracting sector.

Dewer said when he started with the company five years ago it was doing a lot of business with mining contractors because a lot of the mines were outsourcing a lot of their work.

“They were more concentrating on getting their coal to port and looking at that sort of infrastructure,” he said.

Miners too are increasing their fleets and so needing finance.

One such example was Macarthur Coal, which took a $180 million facility to purchase its own mining fleet. That finance was arranged by GE and another lender.

While there are a number of financing choices for mining contractors, what is the best way forward?

According to Dennis, shopping around is the key. “The only thing I see people doing wrong is going to their established bank and leasing from them,” he said.

“We’re refinancing a couple of mines that did their leasing through their major banks and found that some of the covenants these banks have in place have caused them problems.”

Dennis said it could be very costly for contractors and miners who breach these covenants.

“Banks tend to put in place covenants that can have cash flow implications. The banks can call for higher interest rates while the contractor is in breach of the covenants,” he said.

Of course, while shopping around for the best deal is the ideal and using finance can generate the best return, sometimes opportunities arise that can be too good to pass up.

Coal mining contractor Walter Diversified Services managing director Gary Ash said it was important to have appropriate financing disciplines in place but the opportunity cost also had to be considered.

Ash is also a believer in the benefit of building a good relationship with a financier.

His company has a relationship with GE that dates back to when Ash and other members of its management team conducted a management buyout.

“You have to have your financier in place and they have to be part of the process too,” he said. “If they are comfortable with your policies and the way you evaluate them it’s easier. If they are not 100 percent sure then approvals take longer.

“You have to give your financiers enough information so that they can make informed decisions.”

The other tip Ash has for mining contractors is to keep an eye on the gearing levels. A lesson learnt from the 1980s crashes is that gearing is an important thing to consider, even in businesses that have a very strong cash flow.

“You have to make sure your gearing is not too high or too low,” Ash said.

And his final tip: “Don’t fall in love with any piece of equipment.”