Small business owner takes a number of decisions day-in and day-out. However, there are few decisions that demand significant thought process because they influence a long term impact on the cashflows, tax liability and eventual growth of the business. One of those decisions is what to choose for an operating lease or capital lease (or bank loan).
Leasing of Equipment.
The leasing of equipment is very much the same as renting. It’s a type of financing where someone else owns the asset or equipment, with full payment and then lease it to you. Now you have the right to use the equipment and in exchange pay rent. In other cases, the lessor takes instalments for the assets and the more instalments you have paid the more ownership you have for the asset. The agreement clauses vary depending on the terms and type of agreement.
When it comes to leasing equipment, there are two different types:
Operating Lease. Operating leasing is very much the same as the rental agreement because in this type of leasing the ownership remains with the purchaser. The property or the asset will remain in the ownership of the purchaser no matter how many payments have been done in the form of rent. In this type of leasing, payments are noted as operating expenses and are listed in the profit and loss statements. No asset is listed on the balance sheet because the lessee does not own the asset.
Capital Lease. This lease is not different to a loan and also known as a finance lease. Contrary to operating lease, it shifts property rights to the lessee when the contract is at completion. The equipment is listed as a corresponding liability in the statement of financial condition record. On the income statement, not only interest payments can be deducted (which is often a component of total lease payment, but also depreciation/ amortization is recorded as an expense).
As discussed earlier, leasing has both benefits and disadvantages. It is wise to weigh both pros and cons before making the purchase decision.
Benefits
First, let’s examine the pros of leasing an asset.
No or low upfront costs.
The most obvious advantage of leasing is to avoid a large cash outflow at the onset. This is important for start-ups or companies with low cash availability.
No Personal Liability:
Except for special cases, lessors don’t want you to submit any personal guarantee. This is an advantage because it doesn’t create liability for yourself personal, though the business is still liable to pay those obligations.
More Flexibility:
When the contract is at completion, you have the option to either renew the contract or terminate it at the end. Moreover, in some cases, you’d have the choice to purchase the asset by paying a small amount at the end of the contract or for free, depending on the lessor. All of these options bring more flexibility to the lease contract because the lessee can decide what’s best for his or her business. This feature is more useful to acquire capital assets that have a higher pace of innovation. For example, if a business owner is buying an asset today and not sure that about the technological advancements in the next couple of years, leasing an asset will ensure that at the end of the lease term, they are not stuck with an outdated or less-advanced asset, compared to their competitors. Some lessors also provide an option to renew a lease at similar terms and the asset is replaced by its latest (more advanced) version.
Low Maintenance Cost
Depending on the contract and the type of underlying asset, repair and maintenance may be the lessor’s responsibility. Your time is saved, and business interruption is avoided because of such a clause in the contract.
Disadvantages
Now let’s examine the other side of the coin and discuss the disadvantages of a leasing arrangement.
No Ownership:
The most obvious disadvantage of a leasing agreement is that you don’t get to fully own the asset. No matter how much rent you have paid, the property stays with the lessor. Even if you default on your last payment, the lessor is entitled to take the equipment back. As discussed above, some contracts do allow the transfer of ownership at the end of the contract, but that is subject to the completion of the terms of the contract.
Tax Impact:
For operating leases, you can deduct the full lease payment as an expense. This may or may not be a disadvantage compared to financing the equipment through a capital lease on loan. A comparative analysis is needed (a professional accountant can help you with that) to see the impact of lease payment as an expect vs. interest and amortization. One of the major factors in that comparison would be the tax laws of your jurisdiction and what is the maximum allowed amortization percentage for that capital class of asset. The Canadian government also offers incentives in some years to boost investment in the economy by allowing more-than-normally-allowed amortization on capital assets acquired in that particular timeframe (google “Accelerated Investment Incentive” for details). No such special incentives are offered for lease payments.
High Cost:
Generally, lease payment is calculated based on the original asset price with compound interest for the lease term. This makes the leasing option more expensive than a bank loan/ equipment financing if that is available with a Principal plus Interest option.
Lower or No Flexibility:
Since the lessor owns the asset and is expected to contractually get it back at the end lease term, the lessor can set certain restrictions on the use/ maintenance of the equipment. Such restrictions may include limiting the use of an asset to a certain level, binding the lessee to a certain maintenance schedule or using certain vendors for maintenance, oiling etc.
Equipment Financing
An equipment financing is different from an operating lease on so many levels and operates with numerous different functionalities and involves different factors. An Equipment loan is defined as the amount taken as a loan in order to purchase an asset. This loan can be taken from banks, financial institutions or even from individual lenders. The loan is repaid in regular instalments along with the amount of interest. However, unlike the leasing agreement, this mode of financing allows you to have full ownership of the asset even during the financing tenure. Although it might seem hugely attractive, still it has its own pros and cons that may swing your decision one way or the other.
Benefits
The biggest and most prominent advantage of asset or equipment financing is that you get the entire ownership, right from the first day.
Easier to qualify:
If you are new to the business but have a good personal credit bureau; the bank will be more inclined to offer to finance for the equipment. More recently, equipment vendors have also started leasing out themselves and have relaxed their criteria. Thus, this advantage is fading these days.
Building your Business Credit Profile
Just like a personal credit bureau, it is important to develop a credit history with banks for your business. Once you complete a tenure successfully and pay all your dues on time, you manage to have a good reputation which helps in getting more and bigger loans in future with less hassle.
Tax Impact
Since you own the asset, you can claim both interest and depreciation expense. As discussed above, consult a tax professional for the tax impact of both options.
Disadvantages:
Almost every lender would require you to pay a down payment on the loan. The size of this down payment depends on the contract, number of scheduled payments, the number of payments and the time duration of the contract
Maintenance and Repair Costs:
With the ownership of the asset comes the responsibility of keeping it functional and maintained otherwise it is good for nothing.
Outdated Equipment:
As discussed above, unlike certain lease options, once your scheduled payments are over, you still own the asset. If the technology has advanced significantly since then and you want to upgrade, you will need to sell the asset yourself (and there may not be enough buyers, if the asset is too specialized or outdated) and get new financing to procure another one. If the technology is mature, does not change often and the asset has a much longer life than the term of the loan, it is advantageous.
Million Dollar Question: Should I Lease or Buy?
Now comes the initial question, should I buy an asset (getting it financed) or lease? It all depends on the nature of your business and your current financial strategy. Either you choose Equipment leasing or asset financing, the ultimate goal is to get the most out of your limited budget and maximize the wealth of the business.
In our view, the first and foremost factor is the availability of options. Shop around and gather all available options. Once you have those in front of you, ask these questions to yourself:
- Do I have upfront cash available (without affecting my business working capital cycle) to pay for the down payment?
- How much is the useful life of the asset, compared to the term of lease/ loan?
- How mature or evolving is the technology?
- How easy or difficult it would be to get rid of that asset (in terms of salvage value and availability of buyers) if you want to upgrade at the end of the term?
- Are there any restrictions on use, in case of the lease?
- Considering full financial outflow (lease/ loan payments, upfront cost, maintenance cost, salvage value, flexibility of contract etc.), which option gives greater benefit.
The above comparisons, especially the last one, are easier said than done. If stakes are high, we recommend taking a professional opinion on these calculations and tax impact.
Finnection has been a trusted accounting and business consulting partners for small business owners. Answer to questions like above and many other matters, especially their tax impact, is part of business consulting which we offer at no additional cost for our Monthly Accounting Package clients.