How does asset leasing work?

Asset leasing is essentially an alternative to purchasing an item. If a business needs a particular piece of equipment or machinery or use of a vehicle, their first instinct might be to buy it. However, this alternative strategy involves hiring (leasing) the item for a limited period of time instead. 

During the lease period, the business normally has full use of the asset, in much the same way as they would if they owned it.  

The business never becomes the legal owner of the asset under this type of arrangement. 

There are two main types of asset leasing arrangements: a finance lease and an operating lease 

What is a finance lease?

With a finance lease (sometimes known as a capital lease), the business leases the asset for a term that is close to its estimated natural life.  

Throughout this rental period, the business makes monthly rental payments to the finance provider, who is also the owner of the asset. These rental payments will usually add up to the full value of the asset, plus interest. Sometimes, a larger final payment is required, known as a ‘balloon payment’. 

The business is also responsible for ensuring and maintaining the asset throughout the term of the lease. It has been said of finance leases that, while they don’t transfer ownership of the asset to the business, the business still takes on the risks and responsibilities associated with ownership. Furthermore, although the business is not the legal owner of the asset, it still needs to be recorded as an asset on the balance sheet. 

At the end of the rental period, the business has three options: 

• Negotiate a further lease period 
• Arrange for the asset to be sold, with the business receiving a share of the proceeds 
• Return the asset to the provider (also known as the lessor) 

What is an operating lease? 

An operating lease involves the business having access to the asset in the short or medium term – the term of the lease agreement may be significantly less than the asset’s natural life. 

During the lease term, the business makes rental payments to the asset’s owner, before returning the asset at the end of the term. The total repayments are likely to be much lower than the asset’s value. 

The asset will not appear on the business’s balance sheet. 

Which form of asset lease is best? 

Whether you opt for a finance lease or an operating lease, depends on your business’s individual circumstances. Some of the issues to consider include: 

• How long do you need the asset for? A finance lease involves using the asset over a much longer period 
• How long is it likely to be until you want to replace or upgrade the asset? It is much easier to replace or upgrade if you have a short-term operating lease rather than a long-term finance lease 
• Are you prepared to pay for maintenance and repairs? If not, then you will need to choose an operating lease 

Advantages of asset leasing 

Whether you opt for a finance lease or an operating lease, there are a number of reasons why an asset leasing arrangement might be beneficial for your business: 

• As you aren’t purchasing the asset, you avoid the damage to your cash flow that might normally be expected when you buy an item 
• Monthly rental payments are usually fixed at the start of the agreement, so you don’t need to worry about your leasing expenses suddenly increasing 
• As you don’t become the legal owner of the asset, you don’t need to worry about possible depreciation in the asset’s value 
• You need only have the asset for the period in which you need it 
• You may be able to access a higher quality asset than would be the case if you were to decide to buy 
• For accounting purposes, the rental payments are usually tax deductible as a business expense 

Disadvantages of asset leasing 

However, there are also several potential downsides to asset leasing: 

• You never become the owner of the asset, so you can’t sell it for market value, although a finance lease arrangement might allow you to receive some of the sale proceeds 
• Your total repayments during the lease term could be significant 
• If you can’t maintain payments, the asset is likely to be re-possessed 
• Although legally this isn’t a credit arrangement, any potential investors will still regard your lease arrangement as a debt, and will adjust their perceived valuation of your company accordingly 
• The process of setting up a lease agreement can be complex 
• It can be difficult to terminate a lease agreement

Get in touch with the team at Funding Bay to find out which form of asset leases your business better.