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 Advantages and Disadvantages of Leasing:
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 payment. 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 expense 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 that of interest expense, the lease itself is treated differently from debt. Leasing is classified as an off-balance sheet debt and doesn’t appear on company’s balance sheet.
Lease expenses usually remain constant for over the asset’s life or lease tenor, or grow in line with inflation. This helps in planning expense or cash outflow when undertaking a budgeting exercise.
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 out-dated. 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, this providing flexibility to 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 a 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 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 case, the objective of wealth maximization for shareholders is not achieved.
Although 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 of 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, to enter 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.