In this series of articles, I am identifying some profit robbers I have noticed in my 16 years of farm business consulting in Alberta. In Part 1 of this series, I identified depreciation on farm machinery as a significant profit robber. Since depreciation doesn’t affect your bank balance, it is easily overlooked.
High loan payments can negatively affect your farm. Loan payments on a new machine versus a used one are another profit and cash flow robber.
In this article, I will examine, from a unique perspective, how higher loan payments for machinery purchases can negatively affect your farm. I’ll examine how loan payments on a new machine versus a used one are another profit and cash flow robber.
Let’s look at an example for a new combine:
- New combine $750,000
- Trade in $250,000
- Loan amount $500,000
A $500,000 loan amortized over five years at five per cent interest has annual payments of $115,487.40 ($90,500 principal and $25,000 interest in the first year). Can your cash flow actually handle that? In August of 2020, the cash price for CWRS wheat in northern Alberta was $6.25 per bushel, so you need 18,478 bushels to make the annual payment.
Now let’s look at the situation for a three- or four-year-old used combine:
- Used combine $500,000
- Trade in $250,000
- Loan amount $250,000
The $250,000 loan with the same terms as the above example has half the annual payment (i.e. $57,743.70 per year, first year $45,000 principal and $12,500 interest). That’s only 9,239 bushels of wheat, which is half of the above example. In these days of tighter cash flows, a savings of $57,743 is a considerable sum that can improve your cash flow and can be used to pay other expenses or can go directly to your bottom line (i.e. profit).
Building equity on a depreciating asset
Some of you will quickly say, “Wait a minute, principal payments are not an expense, they are building equity.” And I will respond with, “Yes, you are correct, but you are building equity for a depreciating asset.” In fact, the asset is depreciating much faster than you are building equity. Here are my calculations to support that point.
The depreciation on the new combine in the first year (assuming a 20 per cent depreciation rate) is $150,000 versus the principal payment of $90,500, so you are falling behind about $60,000 that year. Compare that with the used machine, for which the depreciation is only $100,000 (using the same 20 per cent rate). The net calculation for the first year is as follows: $100,000 depreciation minus $45,000 principal payment only leaves a gap of $55,000. The important point is that in both cases the machine is depreciating faster than your equity.
Table 1 (further above) shows the complete picture over the full five years of the loan. If we add the depreciation costs over five years, we get the results shown in Table 2 (above). Table 3 (below) shows the costs of a new combine versus used in terms of bushels of wheat.
Therefore, the total interest and depreciation cost for the new combine is about 93,000 bushels of wheat versus 60,000 bushels for the used one, which is a difference of 33,000 bushels or about 20 super B trailer loads of wheat.
An objection to my suggestion for buying used may be, “Good used machines are hard to find and I may get a dud that someone else is trying to unload.” Yes, finding a good used machine will take some time and probably require travel to find a good used unit and you must inspect it carefully. It’s not as easy as going to a dealer for a new one off the lot.
My idea is you could invest some time to save $168,000 in depreciation over five years. Another way to look at it is from a cash flow perspective, you are making half the loan payments and saving $290,000 in cash (principal + interest). As long as the additional cost of repairs on the used machine is a lot less than these amounts, it’s something to carefully think about before buying your next new machine.
Thanks to Allan Sawiak, tax partner with KRP Group in Edmonton, for his input on this article. Look for the third article in this series in the next issue of Grainews, in which I will examine other profit robbers on the farm.