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December 11, 2015

​The Paradox of being Wrong, when you are Right

 

By David Chrestensen, ChFC

A few weeks ago I had a conversation with an adviser to a trucking firm about the value of using 1031 exchanges when replacing high cost over the road tractors. He was adamant that the 1031 exchange process (which can defer taxes), offered only timing value, not operational value, over the client's current process. He was right from the operational perspective, but from a future value perspective when the business is sold, he was far off the mark.

The reason is that an exchange does not impact operations; its actions occur below the EBITDA line on an income statement. A 1031 exchange is a financing tool that allows (requires) the business to reduce its debt by the amount of value obtained from the sale of the old asset. In this client's case, cash from the sale of the old trucks was being added to working capital and the new asset was being financed at 100% of its cost; a strategy often proposed by advisors and by “astute” writers in trucking magazines.

The theory is that the cash can be used for other needs within the business, and though that can often be the case, there is a cost associated with this strategy that does not appear on an operating statement. That cost can be quantified by analyzing the net cash after both operating expenses and SG&A, along with the debt of the business versus other options that are open to the firm. When that is done, a new picture emerges; one that shows the cost of using this cash as working capital, and it is rarely a pretty one.

This client was a medium sized operator, owned by two brothers, with 67 tractors. Their current replacement strategy was to finance 100% of the cost for 6 years, and once paid off; trade the old trucks for new units. Their annual revenue was about $10,000,000 and their EBITDA was in the range of 7% of that number. Using their data as to current and future operating costs, it was determined that the replacement of 9 trucks per year (their standard based on their fleet size) would not be impacted by changing replacement methods.

However, the NET difference in their cash flow and debt at the end of just 5 years was as follows; net after tax cash was UP $475,076 and debt was DOWN $122,785. Since the EBITDA would be the same for either method if the business were sold, but the cash and debt would net against that amount, no matter what multiple they received, continuing their current strategy could cost them nearly $600,000 within five years.

After deciding to make the change, they were made aware of an alternative way to utilize the 1031 exchange process, based on an IRS safe harbor ruling. They have started down that highway with their first transactions, and based on the data, will not only increase their cash and reduce their debt, but more importantly, increase their average EBITDA, making the future much brighter when it comes time to sell!

Interested in learning how exchanges could help add value to your future? Try reaching out to our firm. We have helped a number of businesses improve their cash flow, reduce their debt, and for some, even improve the operating income.

 
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