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Overview
Paying cash for an asset can be a significant drain on your
working capital. Leasing the asset, however, gives you access
to the asset without paying for it all at once . All
forms of leasing are basically rental agreements giving you
(the lessee) the right to use an asset owned by the lessor
(finance company) for a specific period of time in return
for regular payments (rental payments). You can lease
almost anything , from equipment valued at a few thousand
pounds to assets worth millions. Leasing contracts are flexible
and can be tailored to your needs.
When leasing, consider its effects on accounting, reporting,
tax, and your cash flow. This section will give you a general
overview. It does not replace professional advice. You may
wish to consult your accounting and tax advisors before finalising
a lease transaction to reap the maximum benefit and avoid
complications.
How It Works
There are many types of leasing but, fundamentally, all fit
one of two categories:
- Direct Lease . You identify the
asset (and negotiate the price) and arrange for the leasing
company to buy it from the manufacturer (if new) or the
previous owner (if used) to rent it to you.
- Sale-and-leaseback (also called
purchase leaseback). You sell an asset you already own
to the leasing company for fair market value or book
written down value (whichever is less) and then lease
it back.
In both cases, the lessor owns the asset ,
not you, and rents it to you. As with any other rental agreement,
you return the asset at the end of the lease
to the lessor. Some leases grant you an end-of-lease option
to renew the lease at a minimal cost (secondary period) or
to sell the asset to a third party as agent of the lessor.
Often equipment manufacturers themselves act as lessors or have
an affiliated leasing company. This allows them to more easily
help their customers finance transactions. The other two groups
of lessors are banks and independent leasing companies.
Types of Asset Finance
We can generally distinguish three major types of leasing: finance leasing, operating leasing and
contract hire . Although strictly speaking
not a type of leasing, we also include hire
purchase in the following discussion:
- Finance Leasing (Full Payout Lease).
You effectively acquire all financial benefits and risks
without actually acquiring legal title. The leasing rate
is computed to collect the full value of the asset (plus
finance charges) during the contract period. At the end
of the lease, the asset is sold to a third party and
you can receive a share of the sale proceeds (if the
lease is not being extended). Generally, you will not
be able to become the owner of the asset at any time
- unless a private arrangement is made with the third
party. However, you usually have the option to extend
your lease and as you will have paid for almost the full
value during your initial lease period, the rental payments
for subsequent periods will be minimal (sometimes referred
to as "peppercorn rental").
- Operating Lease . Often with a
shorter time frame than financial leasing (always significantly
shorter than the working life of the asset), operating
leasing is more like a regular rental. The lessor expects
to be able to either sell the asset in the second-hand
market or to lease it again and will therefore not need
to recover the total asset value through lease payments.
There may be an option to extend the leasing period at
the end (this negotiation can only take place at the
end of the initial rental period). As with finance leases,
you will not be able to become owner of the asset at
any time but, contrary to financial leases, you will
not share in the sale proceeds.
- Contract Hire . A form of operating
lease (often used with cars and other vehicles) that
includes a number of additional services such as maintenance,
management or replacement if asset is in repair.
- Hire Purchase . This is an agreement
for the hiring of an asset with an option to purchase.
The legal title will pass to you when all payments have
been made. The term of a hire purchase must be significantly
shorter than the working life of the asset. You are able
to claim capital allowances as if you had purchased the
asset outright, gaining immediate use of it. Hire Purchase
agreements are typically written for domestic users,
not so much for business users.
End of Lease Options
At the end of the lease term, you have various
options . Lease contracts can stipulate that you
- return the asset ;
- have the right to act as an agent to sell
the asset to an independent third party; and/or
- can renew the contract or enter
into secondary periods.
It is important for you to anticipate your future needs as each
option has its advantages and disadvantages and will affect
your monthly payments.
Seek the assistance of a professional advisor if you feel you
need help!
Choosing the Right
Type of Finance
All types of financing offer different advantages and it is
important that you assess your circumstances and needs before
committing to a specific finance contract. Click
here for a brief comparison.
For example, if you
- want to own the asset straight away, an outright
purchase (cash or loan/overdraft) might be appropriate;
- may want to own the asset at some point in time and
want to take advantage of instalment payments, hire
purchase might be the best option;
- do not want to own the asset at all but require it
for most of its useful life, consider a financial
lease; and
- require the asset for a period of time significantly
shorter than the useful life of it, consider an
operating lease.
Advantages
- Better Cash Flow . Leasing
gives you access to the asset with minimal up-front
payments and spreads the cost over time. You to
pay for the asset with the income it generates while
minimising the drain on your working capital.
- No debt . An operating lease
preserves your credit options and does not influence
your credit limit as it is generally not classified
as debt but as expense (note that this advantage
does not apply to finance leases!).
- Maximise Financial Leverage .
Your lease can often finance everything related
to the purchase and installation of the asset and
may free up cash flow to pay for items such as training.
- Simplified cash flow management .
Lease payments are usually flat, making cash management
more predictable and easier than with a variable
rate loan. The fixed interest rate of a lease also
helps if interest rates rise.
- Tax advantage . Operating
lease payments are generally tax deductible just
like depreciation charges but are made with pre-tax
money. Cash purchases, in contrast, are made with
after-tax money. Hire purchase agreements allow
the lessee to claim capital allowances.
- Flexible time frames . Leasing
contracts can be structured to fit your requirements.
Use an asset as long as you need it without owning
it forever.
- Hedge against obsolescence .
Depending on your end-of-lease option, just return
the asset to the lessor. You will not have the hassle
of selling the used asset or run the risks related
to residual value and (technical) obsolescence.
- Additional advantages . Some
leases offer additional advantages such as cancellation
options or asset maintenance.
Disadvantages
- More expensive . A finance
lease is usually more expensive than an outright
cash purchase as the payments include finance charges.
However, leasing may cost less than other forms
of financing. Also consider the tax advantages when
making this calculation.
- Additional Guarantees . Depending
on the credit rating of your company, the lessor
might require additional guarantees. These may be
provided by you, your partners or your bank and
could affect your personal credit rating or your
standing with your bank.
- Fixed Term . It may be impossible,
or at least costly, to terminate a leasing contract
early.
- Fixed Interest Rates . Interest
rates are usually fixed throughout the lease which
may prove a disadvantage in times of falling interest
rates.
Things to Watch
out for:
- Return of Asset Conditions.
If you choose to return the asset at the end of
your lease, the condition in which and the place
where it must be returned are important aspects
to consider carefully.
- Notice Period. If your lease
includes the option to renew take note of any time
periods in which to give notice in case you do not
want to renew the contract. Some leasing companies
will automatically renew the contract if you fail
to give notice.
- Purchase Rights. If negotiating
the right to purchase the asset at the end of your
lease, a predetermined fixed price offers more value
as the 'fair market value', which theoretically
is always available to you.
- Maintenance Responsibility.
Clarify which service and maintenance programs are
included in the lease. If you are responsible for
service and maintenance, make sure you do not have
to provide an unreasonably high degree of it.
Frequently Asked
Questions (FAQs)
What kind of equipment can be leased?
lease almost anything, from equipment valued at a few
thousand pounds to assets worth millions.
What is the lease rate or payment?
It is the regular "rental" payment you make under the
lease agreement to gain access to the asset. The lease
rate or payment is primarily determined by the total
cost of the asset, the duration of the lease and the
interest rate level.
What is the lease term?
The period of time you agree to rent the asset from the
lessor.
Glossary
Direct lease . You identify the
asset (and negotiate the price) and arrange for the leasing
company to buy it from the manufacturer (if new) or the
previous owner (if used) to rent it to you. (see also
sale-and-leaseback)
Economic life (useful life). The
period of time during which an asset has economic value
and is usable.
Fair Market Value . Price at which
an asset is sold and bought in the open market.
Lease . A lease is a contract in
which the lessor purchases the asset selected by you
and conveys the use of an asset to you for a specific
period of time at a predetermined rate.
Lease Rate . The periodic rental
payment to the lessor for the use of the asset. The lease
rate is primarily determined by the total cost of the
asset, the duration of the lease and the interest rate
level.
Lessee . The lessee is the user
of the asset being leased, i.e. you.
Lessor . The lessor is the party
who has legal or tax title to the equipment, grants the
lessee the right to use the equipment for the lease term,
and is entitled to the rentals, i.e. the leasing company.
Master lease . A contractual arrangement
which allows you to lease other assets under the same
basic terms and conditions without negotiating a new
contract.
Purchase option . A provision by
which you have the right to purchase the asset at the
end of the lease term, either at a predetermined amount
or its fair market value.
Residual value . The resale value
of the asset at the end of the lease.
Sale-and-leaseback (also called
purchase leaseback). You sell an asset you already own
to the leasing company for fair market value or book
written down value (whichever is less) and then lease
it back (see also direct lease).
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