Lease Financing: Advantages, Disadvantages and Types

Lease financing is a popular financing option for businesses of all sizes. A lease is a contract between a lessor and lessee, in which the lessor agrees to provide the lessee with the use of an asset for a specified period of time. The lessee is then obligated to make periodic payments to the lessor over the life of the lease. In lease financing, the lessee is issued the right to use the asset, but the lessor owns it, and at the end of the lease term, the asset will either be returned to the lessor or the lessee will have the option of either purchasing the asset or renewing the lease.

Advantages

To Lessor

Lessors calculate periodic lease payments based on expected investment yields and can quantify margins between funding costs and transaction costs on lease agreements more easily.

After the lessee chooses the equipment, the lessor purchases it directly from the supplier, preventing the lessee from using the borrowed funds for other purposes and, in some cases, allowing equipment to be priced lower based on fleet or volume sales.

During the lease period, the lessor gets lease rental, which is a regular and assured source of income.

Finance leases transfer all ownership risks and rewards to the lessee without transferring ownership of the asset, so the lessor retains ownership.

Leases are highly profitable since lease rentals provide a much higher return than financing interests.

To Lessee

When a business leases an asset, it won’t have to spend a lot of money acquiring it, but it will be able to use it by paying small monthly or annual rentals.

A leasing agreement can often be arranged faster and easier than a conventional bank loan because additional security is not usually required.

Unlike depreciation allowances or interest charges on bank loans, lease financing offers tax incentives. Lessees can deduct their full lease payments against their income before tax.

Small enterprises can access lease finance more easily than banks because of simpler security arrangements and fewer historical balance sheet requirements.

The lessee pays a fixed amount of rental each year regardless of the increase in the asset’s cost.

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Disadvantages

To Lessor

If the lease agreement does not contain an escalation clause, an unexpected spike in leasing costs can throw the lessor’s entire profit picture out of focus.

The lessee uses the asset carelessly since ownership isn’t transferred, and there is a high likelihood that the asset will no longer be usable after the lease period has expired.

Leasing laws exclude the lessor from the concessional tax paid by the actual users of the equipment, which results in higher equipment costs and higher lease payments.

To Lessee

In most cases, lease financing is limited in its area of operation. Since rentals become due for payment shortly after signing a lease contract, project financing is difficult since new projects do not generate cash until a long gestation period has passed.

Even when the lessee wishes to discontinue a particular business line, he may not be able to terminate the lease contract without paying heavy penalties.

There may be certain tax benefits/incentives that are not available to lessees with leased equipment.

Lessors usually demand advance rent payments when leasing, adding to the expense.

The lessee will not become the owner of the asset unless he decides to purchase it at the end of the lease agreement.

The lessee is not the owner of the asset, which means it cannot be shown on the balance sheet, leading to an understatement of the lessee’s assets.

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Types of Lease Financing

Two main types of lease exist depending on the degree to which lessees assume the risks and rewards of ownership, other than the legal title:

• Financial Leases
• Operational Leases

Financial Leases

In this lease, substantial transfer of ownership risks and rewards is deemed to occur if, at the beginning of the lease, all lease payments amount to 90 percent or more of the fair value of the asset, which is normally its cash purchase price. Interest rates implied in leases are used to calculate the present value of future lease payments.

Through lease financing, the economic use of an asset is acquired by making periodic lease payments to a lessor who owns that asset. The title of an asset remains with the lessor and the asset is returned at the end of the lease period unless otherwise provided for. Due to this contractual obligation, leasing is regarded as a form of financing similar to borrowing. For many companies the leasing of assets represents an important source of financing.

Features of Financial Lease

• The financial leasing allows one party the lessee to use an asset owned by the other (the lessor) in exchange for designated periodic payments.
• The lessee uses the asset and pays rentals to the lessor, who legally owns it.
• The legal owner relies on the ability of the user to generate sufficient cash flows to make lease payments, rather than relying on its assets, capital base or credit history
• The lessee carries the risk of obsolescence, and costs of maintaining the asset in good working condition and insuring it.
• The lessee typically has the right to purchase the asset at the end of the lease contract for a nominal fee.

Financial lease is of three types

1. Direct Lease
2. Sale and Leaseback
3. Leveraged Leasing

(i) Direct Lease: In direct leasing, the company acquires the use of an asset without owning it. There are many types of direct leasing arrangements available to meet the needs of different companies. Manufacturers, finance companies, independent leasing companies, and special purpose leasing companies make up the majority of lessors. Lessors lease assets from vendors or equipment suppliers to lessees.

(ii) Sale and Lease-back: During a sale and lease-back arrangement, a company sells an asset it owns to another party, who leases it back to the company. During the basic lease period, the firm receives the sale price in cash in exchange for meeting its working capital needs and economic use of the asset/equipment. In exchange, the firm agrees to make periodic lease payments and relinquises ownership of the asset. Insurance companies, institutions, finance companies, and independent leasing companies are among the lessors engaging in sale and lease-back arrangements.

(iii) Leveraged leasing: Leveraged leasing involves three parties- the lessee, the lessor and the lender. From a lessee’s perspective, a leveraged lease is no different from any other lease. A lease contract specifies that the lessor will make periodic payments to the lessor over the lease term in exchange for the right to use the asset. However, the role of the lessor has changed. According to the lease terms, he acquires the asset.

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Operating Lease

An operating lease is any type of lease, that is, one which does not fully amortize the asset during the non-cancellable period, if any, of the lease and where the lessor does not rely on rentals for profit during that time. This is not a way of financing equipment purchases. The lessee leases equipment that the leasing company has on hand for a limited time, for example, a car rental. As part of the leasing process, the lessor recovers the capital cost of the equipment through multiple, serial rentals and final sales. The leasing company is responsible for maintenance and obsolescence risks.

Features of Operating Lease

• Lease terms are much shorter than asset economic lives.
• Leases can be terminated by the lessee with a short notice and no penalty is imposed.
• The lessor provides the lessee with the technical know-how of the leased asset.
• The lessor bears the risks and rewards associated with asset ownership.
• The lessor must rely on leasing an asset to different lessees for recovery of his/her investment.