Cash Is King, Even with Iron

Understand that cash flow is in the equipment, and enjoy better communications with financial managers

Construction Equipment - April 1, 2005

Mike Vorster
Contributing Editor

Equipment managers think in terms of owning-and-operating costs and use many different methods to estimate the economic life and minimum hourly cost of buying, operating and finally selling a machine. Accountants unfamiliar with this process worry that equipment managers are setting rates and estimating economic lives without regard for accepted "accounting" concepts. Equipment managers can improve communications by using terms familiar to accountants and presenting their analysis in a format familiar to individuals whose background and training deals more with dollars and cents than with oil and grease.

One tool for improvement is the understanding of cash flow in the iron. We'll use the table on the next page as an example of how to use cash-flow analysis. Here, we analyze a machine purchased for $380,000 in cash, kept for six years or 10,800 hours, and sold for an estimated residual market value of $66,800.

Row 1 gives the anticipated years of ownership, row 2 the anticipated annual utilization, and row 3 the cumulative number of hours worked at the end of each year.

Row 4 covers acquisition costs: $380,000 as a single cash payment at the start of the first year. If the machine had been rented, financed or leased, then this row would reflect any cash payments made as well as the loan or lease commitments due.

Annual operating cash flows are calculated in rows 6 through 11. Row 6 shows the annual income from operations based on a rate of $107 per hour and the utilizations in row 2. Row 7 contains the annual owning costs, and row 8 shows a direct operating costs estimate of $39.89 per hour. Row 9 is the annual cost of repair parts and labor growing with machine age.

Total annual costs (rows 7+8+9) is in row 10, and the annual cash flow from operations (rows 6+10) in row 11. The estimated residual market value of the machine when sold in year 6 is shown in row 12. Combined with the cash flow from operations in row 11, this gives us the net annual cash flow in row 13 and the cumulative cash flow in row 14.

The analysis, extended for another three years, is shown graphically in the accompanying chart (top, right). Line A-B-C represents cumulative cash flow before selling the machine at its estimated residual market value. Line D-E-F represents cumulative cash flow taking into account the estimated residual market value. Point F is the estimated cumulative cash flow for the machine if it is sold after six years (last column, row 14).

This analysis is clear to accountants. First, we've focused on cash flow based on an hourly rate of $107 under certain assumptions. Second, we've shown that the machine will generate a positive cash flow of close to $61,000 if kept for six years and 10,800 hours. Third, we know that six years is not the optimum life, as our cumulative cash flow continues to increase for another year before tailing off. Fourth, and most important, we show that the machine remains in a cash-negative situation right up until it is sold and the cumulative cash flow moves from line A-B-C to line D-E-F. The profit is "in the iron," and we need to keep the machine close to 12,000 hours before it goes cash-positive.

The cash-flow analysis also highlights the fact that our decision to purchase the machine for $380,000 in cash causes the investment to be cash-negative for a long time. Acquiring the machine on a rental purchase agreement, financing it, or leasing it will affect row 4 of the table and can easily remove the large negative cash flows. The permutations and combinations of financing arrangements are virtually endless, but if we assume the machine will be acquired by borrowing 80 percent of the purchase price for five years at 6 percent interest, we show the machine close to cash-positive for the majority of its economic life.

The classic minimum owning-and-operating cost calculation is well understood by equipment managers. It does, however, fall short in three important areas. First, it does not use terms and is not in a format accepted by accountants and financial analysts and does not therefore contribute to communication. Second, it does not emphasize the fact that equipment investments remain cash-negative for a substantial period of a machine's economic life; and third, it cannot be used to illustrate the cash flow improvements possible through innovative financing alternatives. An equipment manager who understands the approach presented here overcomes these shortcomings and merits serious consideration from the financial side of the company.

Cash-Flow Analysis
Row	Categories	Rate	Year
1			0	1	2	3	4	5	6
2	Expected annual utilization		0	1,900	1,900	1,900	1,800	1,700	1,600
3	Cumulative hours worked		0	1,900	3,800	5,700	7,500	9,200	10,800
4	Acquisition Costs		-$380,000
5	Annual Cash flows
6	Income from Operations	$107.00		$203,300	$203,300	$203,300	$192,600	$181,900	$171,200
7	Annual Owning Costs			-$16,160	-$11,671	-$9,737	-$8,623	-$7,881	-$7,344
8	Direct Operating Costs	$39.89		-$75,791	-$75,791	-$75,791	-$71,802	-$67,813	-$63,824
9	Repair Parts & Labor			-$13,697	-$29,581	-$45,465	-$57,725	-$67,608	-$75,247
10	Total Costs			-$105,649	-$117,043	-$130,993	-$138,149	-$143,302	-$146,415
11	Cash Flow from Operations			$97,651	$86,257	$72,307	$54,451	$38,598	$24,785
12	Income from Sale								$66,800
13	Net Annual Cash Flows		-$380,000	$97,651	$86,257	$72,307	$54,451	$38,598	$91,585
14	Cumulative Cash Flow		-$380,000	-$282,349	-$196,092	-$123,785	-$69,335	-$30,736	$60,849
The cash is in the iron at the end of year six, as the sale of the machine combines with cash flow with operations to provide a positive cumulative cash flow of $60,849.