Leasing is becoming a preferred solution to resolve fixed asset requirements vs. purchasing the asset. While evaluating this investment, it is essential for the owner of the capital to understand whether leasing would yield better returns on capital or not. Let us have a look at the advantages and disadvantages of leasing:
What is a Lease or Leasing?
A famous quote by Donald B. Grant says, “Why own a cow when the milk is so cheap? All you really need is milk and not the cow.” The concept of Lease is influenced by this quote. We can compare ‘milk’ with the ‘rights to use an asset’ and ‘cow’ with the ‘asset’ itself. Ultimately, a person who wants to manufacture a product using machinery can get to use that machinery under a leasing arrangement without owning it.
- What is a Lease or Leasing?
- Purpose of Leasing
- Advantages of Leasing
- Disadvantages of Leasing
A lease can be defined as an arrangement between the lessor (owner of the asset) and the lessee (user of the asset). Whereby the lessor purchases an asset for the lessee and allows him to use it in exchange for periodical payments. These payments are called lease rentals or minimum lease payments (MLP). Leasing is beneficial to both parties for availing tax benefits or doing tax planning.
At the conclusion of the lease period, the asset goes back to the lessor (the owner) in an absence of any other provision in the contract regarding compulsory buying of the asset by the lessee (the user). There are four different things possible post-termination of the lease agreement.
- The lease is renewed by the lessee perpetually or for a definite period of time.
- The asset goes back to the lessor.
- The asset comes back to the lessor and he sells it off to a third party.
- Lessor sells to the lessee.
Purpose of Leasing
The purpose of choosing a lease can be many. Generally, a lease is structured for the following reasons.
Benefits of Taxes
The tax benefit is availed to both the parties, i.e. Lessor and Lessee. Lessor, being the owner of the asset, can claim depreciation as an expense in his books. And therefore get the tax benefit. On the other hand, the lessee can claim the MLPs i.e. lease rentals as an expense and achieve tax benefit in a similar way.
Avoid Ownership and thereby Avoiding Risks of Ownership
Ownership is avoided to avoid the investment of money into the asset. It indirectly keeps the leverage low and hence opportunities of borrowing money remain open for the business. A Lease is an off-balance sheet item.
Advantages of Leasing
Balanced Cash Outflow
The biggest advantage of leasing is that cash outflow or payments related to leasing are spread out over several years, hence saving the burden of one-time significant cash payments. This helps a business to maintain a steady cash-flow profile.
While leasing an asset, the ownership of the asset still lies with the lessor whereas the lessee just pays the rental expense. Given this agreement, it becomes plausible for a business to invest in good quality assets which might look unaffordable or expensive otherwise.
Better Usage of Capital
Given that a company chooses to lease over investing in an asset by purchasing, it releases capital for the business to fund its other capital needs or to save money for a better capital investment decision.
Leasing expenses or lease payments are considered as operating expenses, and hence, of interest, are tax-deductible.
Off-Balance Sheet Debt
Although lease expenses get the same treatment as interest expenses, the lease itself is treated differently from debt. Leasing is classified as an off-balance sheet debt and doesn’t appear on the company’s balance sheet.
Low Capital Expenditure
Leasing is an ideal option for a newly set-up business given that it means lower initial cost and lower CapEx requirements.
No Risk of Obsolescence
For businesses operating in the sector, where there is a high risk of technology becoming obsolete, leasing yields great returns and saves the business from the risk of investing in a technology that might soon become outdated. For example, it is ideal for the technology business.
At the end of the leasing period, the lessee holds the right to buy the property and terminate the leasing contract, thus providing flexibility to the business.
Disadvantages of Leasing
Lease payments are treated as expenses rather than as equity payments towards an asset.
Limited Financial Benefits
If paying lease payments towards land, the business cannot benefit from any appreciation in the value of the land. The long-term lease agreement also remains a burden on the business as the agreement is locked and the expenses for several years are fixed. In a case when the use of an asset does not serve the requirement after some years, lease payments become a burden.
Reduced Return for Equity Holders
Given that lease expenses reduce the net income without any appreciation in value, it means limited returns or reduced returns for an equity shareholder. In such a case, the objective of wealth maximization for shareholders is not achieved.
Although a lease doesn’t appear on the balance sheet of a company, investors still consider long-term lease as debt and adjust their valuation of a business to include leases.
Limited Access to Other Loans
Given that investors treat long-term leases as debt, it might become difficult for a business to tap capital markets and raise further loans or other forms of debt from the market.
Processing and Documentation
Overall, entering into a lease agreement is a complex process and requires thorough documentation and proper examination of an asset being leased.
At the end of the leasing period, the lessee doesn’t end up becoming the owner of the asset though quite a good sum of payment is being done over the years towards the asset.
Maintenance of the Asset
The lessee remains responsible for the maintenance and proper operation of the asset being leased.
Limited Tax Benefit
For a new start-up, the tax expense is likely to be minimal. In these circumstances, there is no added tax advantage that can be derived from leasing expenses.
To summarize, lease finance is appropriate for an individual or business which cannot raise money through other means of finance like debt or term loan because of the lack of funds. The business or lessee cannot even arrange the down payment money to raise debt. The lease works best for him. On the other hand, the lessor, who wants to invest his money efficiently, becomes the financier for the lessee and earns the interest.
To take an informed decision regarding the use of various types of lease finance, we may have a look at the comparison of lease finance with other forms of finance.