As a business owner, we are sure that the phrase “We need new equipment” must send you into a cold sweat. As much as equipment is vital to the company operations; whether it be replacing old, outdated equipment, or expanding your operations, equipment is expensive.
Most companies, whether they have been around for years and have a solid place in the market, or whether they are a startup, will battle to cover the cash layout of a new piece of equipment. In fact, most financial advisors lean away from using the working capital of the organization for buying new equipment, and rather promote equipment financing.
Bearing this in mind, we thought we would take a look at leasing and the intricacies of how this financing option could be beneficial to your company. We thought we would break down the two most common leases and map out their differences. So, if you have wondered the difference between finance leases vs. operating leases, read on. We unpacked the difference of terms, financing benefits, and how it can be used to benefit your company. Let’s start off with the main differences between the two leases and why a company would choose one over the other.
Definition of a Finance or Capital Lease
A finance lease is also known as a capital lease or $1 buy-out lease. It is an option for the company to lease a piece of equipment for the majority of its useful life with an intention of owning the equipment at the end of the term.
These leases have a balloon or residual at the end of the term that will need to be paid out to the lessor for the lessee to take over title ownership of the equipment.
This kind of lease is usually taken when the equipment that the company needs will not become obsolete over a period of time. With technology evolving as quickly as it is, the equipment can become redundant easily and will need to be replaced and upgraded over a period of time. In the case of a finance lease, this will not be a concern. Equipment acquired with a capital lease is expected to last a number of years, and way beyond the leasing period.
Definition of an Operating Lease
An operating lease or Fair Market Value Lease is finance taken on equipment for a period of time less than its useful life. So, in the case of equipment that will need to be regularly upgraded and replaced, this is the type of lease that a company would sign for.
The equipment can be acquired over the agreed-upon duration of the period and then either returned to the lessor for an upgrade or re-leased for another set period of time. This will reduce the risk of obsolete equipment being purchased for the company as there is no transfer of ownership.
Not only does this allow more flexibility for the company to continually grow and expand, but it also reduces the risk of large sum payments on equipment that will only be used for a limited period of time. So, when you need to pick between a financing lease vs. an operating lease, you will need to work out how long the equipment will last. Will you need to continuously upgrade equipment, or can you eventually own it to use it for a number of years to come?
Finance Lease Vs. Operating Lease: The Terms of the Lease
The next thing we need to look at are the differences in terms of the lease. Most terms of leases will differ from lease to lease, especially depending on the equipment and needs involved. But there are some terms which are more likely to pop up in a financing lease and operating lease respectfully.
The Residual or Balloon Amount
A finance or capital lease will usually have a residual or balloon amount due at the end of the lease as the lessor will be taking over ownership of the equipment.
The residual amount is usually calculated at the beginning of the term and is the estimated value of the equipment at the end of its lease term or useful life. When calculating the monthly payments due for the equipment, the lessor will take the residual amount of the equipment into consideration, where the residual value diminishes the longer the useful life or lease period of an asset is.
In the case of an operating lease, because the lessee won’t be taking over the equipment, there will be no residual at the end of the term, and they can decide whether they want to return the equipment, upgrade or re-lease it for another period of time.
Running Costs and Administration
In the case of an operating lease, because the lessor fully owns the equipment, and the title will not be handed over to the lessee at any point, they will be fully responsible for the running costs.
Maintenance, insurance, transportation and any other fees will be the responsibility of the lessor. These costs will usually be included in the total monthly payments but will be carried out by the lessor. In some cases, they will also include training in these costs. Should the lessee company’s staff need training on the equipment, the leasing company will be responsible to provide one and send technicians to regularly check up on the equipment.
For a finance lease, on the other hand, the lessee is usually responsible for these costs. Service and maintenance plans can be worked out for a period of time, but after the lease comes to an end, the lessee will be fully responsible for servicing, repairs and maintenance costs. Should the lessee require any of the additions included to the lease, it will be added to the monthly fees and will be relevant for the stipulated time.
An operating lease will usually be around 12 to 60 months in duration, with the lease term being less than 75% of the estimated economic life of the equipment. That means that the total payment value made by the lessee over the term of the lease cannot exceed 75% of the total value of the equipment.
On the other hand, a capital lease term will equal or exceed 75% of the asset’s estimated useful life. In terms of the present value of the equipment, it should equal or exceed 90% of the total original cost of the equipment in the case of a finance lease while the lease payment is less than 90% of the equipment’s fair market value in the case of the operating lease.
Let’s Talk Accounting
Now that we have dealt a bit with the finance aspect of the lease, let’s take a look at how they should be reported.
Finance leases are considered as purchasing an asset and need to be recorded as such on the company’s books. A capital lease, due to the fact that the lessor will eventually own the equipment, will impact on companies’ financial statements, influencing interest expense, depreciation expense, assets, and liabilities.
Capital leases are counted as debt. They depreciate over time and incur interest expense. It is considered a loan (debt financing), and interest payments are expensed on the income statement. The present market value of the asset is included in the balance sheet under the assets side, while depreciation is charged on the income statement. The loan amount, on the other hand, which is the net present value of all future payments, is included under liabilities.
Operating leases are far simpler to deal with. Because the lessee will not be taking over ownership of the equipment, it will merely be considered as expenses in the books. This is rather a contract that allows for the use of the equipment for a period of time but does not convey any ownership rights of the asset.
Operating leases are also known as off-balance sheet financing which essentially means that the leased equipment and associated liabilities of future rent payments are not included on a company’s balance sheet. The company will also not consider the depreciation of the equipment.
This will mean that the company is still open for lines of credit and will be more attractive to investors due to the fact that money is not tied up in the equipment.
Based on all of this, you might be wondering which lease is better for your company. The answer lies in what your specific needs are and what equipment you will be needing for your company. An operating lease is financially less risky for your company and is perfect for equipment that will need to be handed back and upgraded over a period of time. A finance or capital lease, on the other hand, is more suited for the equipment that you would like to own at the end of the term, but cannot afford to purchase in a lump sum.
It is important to ensure that you have the right financing company on your side when you decide to sign a lease. Not only do they need to be credible and reliable, but they should take your needs and economic trends into consideration when advising you on the lease. So, shop around, and do some homework on various financing companies and find one that will help you tailor a specific package especially for your needs.