The case
Ricardo, single at age 29, lives at his parents' home. He is a claims supervisor at an insurance company earning $7,500 after tax. Two years ago, he used his savings to purchase a car costing $60,000, which he gave to his cousin Winston on a "work-to-own" basis (private taxi) with a verbal agreement to pay $800 per week for three years. After that, the vehicle would be transferred to Winston. Winston would handle all of the service and repair costs whilst Ricardo would take care of the annual insurance premium of $4,500. Over the past 24 months, Winston missed only two payments because the vehicle was undergoing maintenance on separate occasions.
Three months ago, Ricardo made a second purchase of an identical vehicle and started renting it to friends, relatives and good referrals. So far, the car has been out for three days each week and the daily rate is $250. He has to pick up the annual insurance cost of $6,000 in addition to all service and routine repairs, which is estimated at $1,500 bimonthly.
He is also expecting a retroactive payment of $50,000 (before tax) from his employers in two months time and is seriously contemplating leaving his job to do the transport business full time.
Nick's Assessment and Advice
Risks
Interestingly, the work-to-own concept is becoming quite popular these days and many individuals are considering it as an alternative means to generate passive income. This does not mean that it comes without risk. Apart from the obvious accident, theft or fire there is also the risk of exposure to liability from third parties such as passengers and the public. Whilst some risks can be minimised with: good management, anti-theft devices, GPS's and so on, there are some risks that simply must be transferred to an insurance company.
If the vehicle owner fails to disclose a material fact of how the vehicle is being used (privately or commercially) the insurance coverage could be voided or claims denied. This naturally puts the financial burden squarely on his shoulders of the owner. We will assume that Ricardo's knowledge in the industry would guide him accordingly. However, for the uninitiated would-be car business person, proper counsel should be sought to ensure that the right type of insurance coverage in place.
There is also the risk that the expected cash flows may not come in as planned. One way Ricardo can deal with this is to collect his fees up front or at the beginning of each period instead of at the end.
A "no credit" policy is a surefire way to sustain a business financially whilst it is in the startup stages. There is also the reality that the negative cash flows (cash out) could exceed projections so he must keep tight handle on these costs as they can erode any profits he hopes to earn that will potentially replace his salary.
There are also legal risks that could arise if either party fails to keep their end of the bargain. To ensure there is recourse, a well-drafted legal contract should be put in place outlining the terms and conditions for each line of business (lease financing, lease to own and rental). Whilst it may not prevent something from happening, it does serve as a deterrent and identifies each party's roles and responsibility.
Financial analysis
Now that we have covered some of the key "what if" scenarios, we will take a closer look at Ricardo's numbers and the possibility of doing the business full time. At the moment, Ricardo is not dependent on the cash flows from the cars. So, whether he makes a profit or a loss, it is not a threat to his livelihood. These cash flows will, however, be affected once he starts to draw money for daily living, which will affect his ability to further capitalise and expand the business from retained earnings.
Based on the information shared, we have calculated Ricardo's total monthly gross revenue as $6,200 with $3,200 from Winston ($800 x 4 weeks) and $3,000 from rental ($250 x 3 days x 4 weeks). Out of this figure we made an allocation of $3,333 ($1,667 x 2 vehicles) ($60,000 / 36 months = $1,667) to cover the replacement cost of each vehicle over a three-year period.
From an accounting standpoint, this is considered depreciation and should ideally be set-aside after being charged to the business. The allocation is even more critical for the work-to-own contract when Winston acquires full ownership at the end of the period.
When we stack up the two lines of business we calculate the net monthly profit (counting for maintenance and insurance) to be $1,242 ($1,158 and $83 work to own and rental respectively) hardly enough to replace his monthly salary.
Ricardo has to increase his net income and the first step would be to get the rental up to full capacity, which we conservatively assumed to be five days per week. At that level the car could yield $2,083 per month bringing his net income to $3,242, which is $4,258 less than his current paycheck of $7,500.
Based on these numbers the rental may be the better option for a higher return on investment, however it may attract more risk when compared to the consistent contracted payment system of $800 per week with the "work to own".
Additionally assuming all goes well; at the end of the three-year period he would still have the rental unit whereas the work-to-own unit would be passed to Winston. He can continue to collect a rental income even after he has fully allocated for the asset's replacement.
Capital
Based on a net rental income of $2,083 per unit and an income shortfall of $4,258 Ricardo has to add two more cars to his fleet to justify giving up his job. Assuming that another vehicle costs $60,000 with insurance of $6,000 Ricardo would need $132,000 to expand his asset base.
With the retroactive pay of $37,500 after taxes ($50,000 x 75 per cent) he has a shortfall of $94, 500 to fill (this is assuming also he had set aside money to replace Winston's car, if not the shortfall is bigger). Seeing that he is still gainfully employed he could leverage his paycheck to borrow the capital needed but it would entail a loan payment of say $1,961 ($94,500, 5 yrs, nine per cent) that encroaches on the income of one of the two new cars.
Strategy
Assuming he does not have any other cash lying around, Ricardo cannot yet leave his full-time job.
In the meantime, he can focus on increasing the rental business to full capacity from three to five and even to seven days per week and consider increasing rates from $250 to $300. He should also consider eventually shifting his business model from "work to own plus rental" to purely "rental" assuming there is sufficient demand.
Until he can add enough units with adequate net positive cash flows to replace his monthly paycheck, he should continue to work and save as much as he can both from his job and his promising business venture.