March 29, 2024

Is Fleet Leasing Right for your Company?

by Fred Drozdoff, Vice President and Senior Transactor, CitiCapital Bankers Leasing
Introduction
Alarge east coast-based electric utility that I first called on 25 years ago had a “no lease” policy. The stated reason was that the AA rated company had plenty of cash and a relatively cheap source of funds, such as A-1 rated commercial paper. In reality, the true cost of funds is not short-term money, but rather the utility’s incremental cost of funds; that is the combination of short, medium and long term funds plus the cost of equity (hurdle rate of return on equity). Twenty-five years later, following successive downgrades to BBB (two ratings above junk status), a new financial management regime and a financially informed fleet manager have put this utility in a different frame of mind, and it is are now planning to lease its fleet. One big advantage for the fleet manager will be freedom from the timing constraints of the company’s capital budget policy, where budgetary approval and funds are not secured until early January. This timing is out of synch with the normal fleet production calendar, leaving him scrambling to submit his orders to the manufacturers before the factories close their production lines. By leasing instead of purchasing his vehicles, he will be free of this constraint.

In another US electric utility, a key consideration for the fleet manager is a reduction in his operating budget. Again, a “no lease” policy has been in effect for over 25 years, and the company, which was AA rated in the early 1980’s, is now struggling to maintain a BBB- rating. This electric utility still enjoys bank loyalty and can raise funds through its revolving credit facility, although is shut out of the commercial paper market that had provided an inexpensive source of funds in the past. The fleet manager is charged with operating expense, and at the mandate of financial management, must decrease his operating budget each year; this year he was granted only half of the $6 million budget he requested. As a result, needed maintenance is delayed until the last possible moment. But delayed maintenance ultimately results in higher costs - the cost of removing a rust spot is small, but once that rust spot turns into a hole, it becomes a costly repair job. Because of the diligence of this conscientious fleet manager and his very dedicated personnel, vehicle downtime has not yet become a problem. However, the fleet manager acknowledges that his aging fleet cannot keep up with a continuous operating deficit and it is only a matter of time before he will have to deal with vehicle downtime and high maintenance costs.

There is a financial solution that would satisfy the needs of the treasury group to improve cash flow and realize low financing rates, while meeting the fleet manager’s objective to have an adequate budget to maintain an efficient fleet – a tax TRAC lease structure that qualifies as a tax lease for Federal tax purposes and a capital lease for accounting purposes. With a tax TRAC lease, the lessor retains the tax benefits of depreciation in exchange for lower lease rates for the lessee. In addition, the rent expense for the fleet is classified as interest and depreciation expense on the P&L, rather than part of the operating budget.

For those electric utilities that have made the decision to lease, what were the drivers for that decision?

From a financial perspective, a properly structured lease can provide off-balance sheet financing. While recently instituted accounting rules make this type of lease more difficult to structure, it is still easier to accomplish for fleet than for other corporate assets, such as computers, office equipment and furniture, because the fair market value of a vehicle can be more readily established. There are a number of ways to structure a fleet lease from an accounting and tax perspective and the optimal structure depends on the utility’s financial situation. However, the terms and conditions of that lease must be compatible with the fleet manager’s objectives, especially in the case of a bundled, full-service lease that may include services such as maintenance management, supplying fuel cards and vehicle procurement. This decision raises implications not only for the fleet manager, but also for the entire fleet work force and the fleet vendor relationships.

Beyond tax and accounting criteria, finance and fleet management should review other leasing considerations. For example:

  • Is the lessor capable of funding multiple assets, including component assets for line trucks and other equipment types sourced from multiple vendors?

  • Can the lessor provide the fleet manager with records and reports that enable him to allocate leasing costs to the selected and appropriate departments and cost centers?

  • Does the lessor have the capability to pay for these assets on a timely basis? The lessor should be able to pay vendors within 48 hours of acceptance so the fleet department can take advantage of early payment discounts. Prompt payment will also help in negotiating lower equipment prices.

  • Is each individual asset treated separately, so that the fleet department can determine the proper lease term and residual (balloon) value?

  • Does the lease program give the fleet manager and operating team adequate control over use of the equipment?

  • Are lease terms and residual values flexible enough to realistically equate value at the end of the lease so there are no payments due to the lessor at expiry (lease end)?

  • Will the lease reduce capital expenditures, thereby allowing the lessee to reduce debt, repurchase stock and obtain higher returns on investment of assets that are essential to electric production?

  • Will the lease improve financial ratios, such as return on invested capital, and improve cash flow?

Additional information the fleet manager will want to know is:

  • Will the fleet manager still be able to make decisions on asset turnover and usage without penalty from the lessor?

  • Does the lessor provide web technology so that paperwork is kept to a minimum? Does the online system complement internal systems and provide asset management control?

  • Will the annual budgeting process be simplified? By leasing, will the company avoid the “scramble” to order fleet equipment because capital budgets are not set until the beginning of the calendar year?

  • Does the lessor offer a wide enough range of leasing options to provide the best financing solutions? For example, some lessors can offer only 5 or 7 year lease terms, while a truck may have a 15 year useful life.

  • Can the lessor submit detailed rental/payment invoices to numerous departments and profit centers? Does the lessor allow decentralized payment of invoices?

These are only some of the questions companies must ask to ensure their financial and fleet management objectives will be met. The “lease - no lease” decision must be a joint effort, as the implications go far beyond the financials. If the fleet manager thinks there are specific benefits to leasing the company fleet rather than ownership, he should push to take a leadership role in the lease vs. buy decision.

Disclaimer: CitiCapital does not provide legal, tax or accounting advice. You should seek and rely on advice from your own auditors, accountants, and/or individual counsel.

About the Author
Fred Drozdoff is Vice President and Senior Transactor for CitiCapital Bankers Leasing. He has over 30 years of experience in the leasing industry and has been calling on the electric utility industry for over 25 years. Fred can be contacted at : fredrick.drozdoff@citigroup.com.