When financed equipment becomes obsolete during a loan — whether because new technology has leapfrogged the existing design or regulations have made the equipment unusable — the borrower remains responsible for the remaining loan balance. This situation also triggers an impairment test that compares the estimated future cash flows the asset can generate against the asset’s current value on the company’s balance sheet.
If a printing company’s digital press is carried on the balance sheet at $400,000, becomes obsolete due to new technology, and is estimated to generate $3,000 per month for the next 10 years, the company would work through the following process:
- Calculate total estimated future cash flows: 10 years × $3,000/month × 12 months = $360,000
- Compare to the asset’s carrying value on the balance sheet: $400,000
- Because the carrying value ($400,000) exceeds the estimated future cash flows ($360,000), the company must write down the asset — reducing its value on the balance sheet and recognizing an impairment expense on the income statement for the difference.
This impairment expense reduces the company’s reported profits and can trigger technical loan defaults by pushing key financial ratios outside the thresholds required by the loan agreement.
As a result, the borrower may need to:
- Add additional collateral to the loan
- Sell other assets or bring in outside investment to pay down debt
- File for bankruptcy if no other options are available
If the write-down only creates a problem with the equipment loan itself, pledging additional collateral can offset the lender’s risk from the reduced asset value. However, because the write-down also lowers the asset’s carrying value, it can violate the terms of other outstanding loans where the company is required to maintain certain ratios — such as a debt-to-equity ratio — within agreed levels.
To bring those ratios back in line, the company may need to sell assets, inject personal funds, or accept outside investment to pay down debt. If none of those options are available, bankruptcy may be the only remaining path.
If you want to avoid ending up in this situation, read on for how to manage obsolete financed equipment, how it can affect your loan and business credit, and how to work with your lender toward a solution.
Obsolete Equipment Impairment Test
Whether new technology has made your machinery outdated or a new regulation has restricted its use, the first step after learning equipment is obsolete is to run an impairment test. This checks whether the asset is still worth what your balance sheet says it’s worth, using the following three-step process:
- Get the current carrying value of the asset from your balance sheet.
- Estimate the total future cash flows the asset will generate over the rest of its useful life.
- If the estimated cash flows in step 2 are greater than the carrying value in step 1, no write-down is required. If the carrying value is greater, you must calculate the impairment charge using this formula:
Impairment charge = Carrying value of asset on your balance sheet − Current fair market value of asset
Example: You’re financing an asset carried on your balance sheet at $500,000. New technology comes out that drops the market value of your equipment to $200,000. You estimate the equipment is still usable and can generate $550,000 in cash flows over its remaining life.
Because the $550,000 in estimated cash flows exceeds the $500,000 carrying value, no write-down is required and nothing changes.
However, if you estimated only $400,000 in future cash flows, that amount falls below the $500,000 carrying value and a write-down would be required:
Impairment charge = $500,000 (carrying value) − $200,000 (fair market value) = $300,000
The $300,000 impairment charge is a non-cash expense recorded on your income statement — you don’t need to come up with cash immediately to cover it. However, the tax treatment of impairment losses can be complex, so consult your tax professional to understand how this affects your specific situation.
Before moving on, review the terms of all your outstanding business loans to check whether this write-down has triggered a technical default in any of them. If it has, here’s how to work through it.
Technical Default Following Impairment
Even if you’re able to keep making payments, a write-down can trigger a technical loan default if it violates one of your loan covenants, such as:
- Causing your debt-to-equity ratio to exceed an agreed threshold
- Lowering your net worth below an agreed minimum
- Pushing other financial ratios outside of agreed levels
Example: You’re required to keep your debt-to-equity ratio below 0.3. Before the $300,000 write-down, your balance sheet looks like this:
$1,500,000 Assets = $300,000 Debt + $1,200,000 Equity (Debt-to-equity ratio: 0.25)
After the $300,000 write-down, your balance sheet becomes:
$1,200,000 Assets = $300,000 Debt + $900,000 Equity (Debt-to-equity ratio: 0.33)
Your ratio has risen from 0.25 to 0.33, putting you in technical default. Depending on your lender and loan terms, they could call the loan due — though this is unlikely, since obsolete equipment is harder to sell and recovering the full balance through liquidation would be difficult.
More likely, the lender will ask you to sign a covenant waiver, which allows you to continue with the loan despite the breach. They may charge a fee and increase your interest rate to compensate for the added risk. Keep in mind that a waiver is not guaranteed; lender willingness depends on your relationship, repayment history, and the overall health of your business.
That said, signing a covenant waiver may not be your best option. Depending on your situation, it may make more sense to use available cash to pay off other outstanding debt. Doing so reduces both your assets and your liabilities together, which can bring your debt-to-equity ratio back within the required range.
Example: If you use $200,000 in cash to pay off other debt, your balance sheet now looks like this:
$1,000,000 Assets = $100,000 Debt + $900,000 Equity (Debt-to-equity ratio: 0.11)
With your ratio back in compliance, you’re in a stronger position to negotiate with your lender — for example, rolling the unpaid balance on the obsolete equipment into a new equipment financing loan.
Options to Move Forward
You can’t use your obsolete equipment as a trade-in on a new model while your lender still holds a lien on it, but there are several paths forward:
- Roll the difference into a new loan. Your lender keeps your business and continues earning on a larger loan, as long as you can make regular payments. They release the lien on the old equipment so you can sell it or trade it in, and the new equipment serves as collateral on the new loan.
- Pledge additional collateral. You can offer other business assets — or even personal assets, such as a stock portfolio — as additional collateral to secure the existing loan. This approach makes sense if the obsolete asset is still generating revenue and you’re confident you can repay the balance.
- Lease new equipment instead of buying it. If you need new equipment to stay competitive but can’t do anything about the obsolete asset, leasing may be the right move. You get access to current technology without taking on the risks of ownership, and most leases include maintenance or replacement service level agreements (SLAs) that protect you from major repair costs. The tradeoff is that leasing is a pure operating expense — you’re not building any equity in the asset.
When financed equipment becomes obsolete, you remain responsible for the remaining loan balance. The first step is to compare the asset’s carrying value on your balance sheet against the estimated future cash flows it will produce. If cash flows are higher, nothing changes. If the carrying value is higher, you’ll need to write down the asset and work with your lender to find the best path forward. Depending on your situation, that could mean continuing your current loan, refinancing and rolling into a new loan, or leasing new equipment. If needed, bringing in outside investment or using personal assets to cover the balance can help keep the situation from escalating further.
National Funding does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
