This brief guide is intended to help you better understand the many ways leasing can help your customers manage their business, systems solutions and capital more effectively.
Benefits of Leasing for Your Customers
Conservation of Capital
With a lease, your customers’ capital isn’t tied up in equipment or system costs. It’s free to be spent on other items such as additional office space, training or personnel.
Leasing allows your customers to finance up to 100% of the equipment cost plus certain “soft” costs such as maintenance, delivery and insurance right in the lease, minimizing up-front cash requirements.
Your customers can lock-in payments now while avoiding the risk of inflation in the future and simplifying the budgeting of monthly payments.
Leasing allows your customers to structure payments to fit their budget. We offer a variety of traditional and customized structures to meet their needs.
Easier Cash Flow Forecasting
Fixed monthly payments help your customers’ budget money into the future.
Purchase and Renewal Options
At the end of the lease, your customers may choose to purchase the equipment, upgrade to a new system or continue to lease via an ongoing renewal of their contract.
Leasing keeps equipment and systems up to date. As your customers’ businesses grow, their equipment may become obsolete, or the technology which was state-of-the-art yesterday, may soon become outdated.
Leasing offers your customers the flexibility to upgrade to new and better technology to match their current and future needs.
Leasing allows your customers to deduct monthly lease payments on a true lease as an operating expense. Additionally, leasing may help customers avoid the Alternative Minimum Tax (AMT) by reducing their AMT Income.*
Off-Balance Sheet Financing
In some instances your customers may be advised to keep their equipment “off-balance sheet.” Depending on the lease structure and the accounting treatment, their lease may qualify for off-balance sheet treatment, which may assist them in acquiring the equipment they need while:
- Maintaining compliance with bank and loan covenants
- Staying within capital budget constraints
- Improving their financial position
Leasing doesn’t tie up lines of credit. So your customers have more capital at their disposal when they need it.
Benefits of Leasing for Your Business
The benefits associated with leasing are mostly economic. However, many times an organization will justify leasing for convenience. The following factors are all reasons why organizations use leasing to their advantage:
- No down payment required – a bank loan, for example, usually requires a down payment. Payments are based on equipment cost less any down payment. A lease requires no down payment and in the case of a Fair Market Value (Operating Lease) the residual value is factored into the lease resulting in lower lease payments.
- No large initial outlay of cash – if using cash to purchase equipment.
- Conserves working capital (working capital is current assets less current liabilities) – typically don’t want to use working capital for medium-term financing needs.
- Tax benefits are transferred from lessor to lessee.
- Structured leases are available to help manage budgeting cycle and meet cash flow needs – a step lease, for example.
- Bundle hardware, software, and services into a lease.
Off Balance Sheet Financing
- Typically for operating leases. Neither the asset nor the debt is reported on the balance sheet. Income statement shows lease payment as an operating expense.
- Impact on Financial Ratios – Current Ratio (a measure of liquidity), Return on Assets (ROA) (a measure of profitability), and Debt to Equity ratio (a measure of capital structure):* Current Ratio = Current Assets/Current Liabilities – impact when comparing lease to purchase with either cash or bank loan. In case of purchasing with bank loan, equipment becomes asset, but not a current asset, and the loan becomes a current liability. The current ratio is lowered as a result of a higher value for current liabilities. In the case of purchasing equipment with cash, the equipment becomes an asset, but not a current asset. Current liabilities are not impacted because no financing is used to acquire the equipment. However, cash is reduced causing the current ratio to be lowered. An operating lease has no impact on either current assets or current liabilities.* Return on Assets (ROA) = Net Income/Total Assets. When financing with bank loan, total assets increases, but net income decreases (must make loan payments). Net result is lower ROA. When purchasing with cash, total assets remains the same (cash is replaced by value of equipment), hence there is no change in ROA. However, with an operating lease, net income decreases by the value of the lease payment (usually less than that for a bank loan), but total assets remains the same. Net result is a larger ROA.* Debt to Equity = Total Debt to Shareholder’s Equity – this ratio is also known as leverage. Shareholder’s equity is the net result of total assets less total liabilities. This ratio is affected when purchasing with bank financing (loan). Total debt is increased and shareholder’s equity is decreased causing this ratio to be higher than compared to leasing. With an operating lease there is no impact on either debt or equity.
- Note that operating leases are disclosed in the Footnotes of the financial reports.
Impact on Earnings
- Depreciation – for a cash purchase net income is affected by deducting depreciation for the equipment purchased – normally on a linear basis.
- Depreciation plus Interest – in the case of purchase through bank financing (a loan), net income takes a double hit with deductions for both depreciation and the interest expense. Depreciation remains the same throughout the useful life (from an accounting
standpoint) of the asset. Interest is greater in the early periods of the loan term and decreases in the latter periods.
- Operating Lease – for an operating lease, the monthly lease payment is the only expense item that affects net income. Comparing this to the above case of depreciation plus interest expense, more often than not lease payments in the early periods of the
lease is likely to be less than depreciation plus interest expense. This causes earnings (and corresponding, earnings per share) to be higher.
- Lending Covenants – many times lending institutions (banks) impose lending covenants, or restrictions, based on the value of the debt to equity ratio. That is, banks will limit the company’s ability to borrow money if their debt to equity ratio is higher than what the bank is comfortable with. Operating leases do not affect the debt to equity ratio leaving the company the ability to borrow if necessary.
- Book Losses – operating leases can preclude potential book losses. Assume an asset was purchased but because of obsolescence (this happens with technology related assets) has a zero book value before the end of its depreciation schedule and becomes useless to the company. If this is a material transaction (significantly impacts financial statements), then the auditors may require that the asset be written off. Such an unexpected write-off causes a loss that can often be a big hit to earnings. With an operating lease, the asset is off balance sheet. If the asset becomes obsolete there is no asset to write off.
- Leasing is a hedge against technology, particularly with respect to operating leases where the lessor takes a residual position – the burden of technological risk is borne by the lessor. At the end of the lease term, the lessee has the option to return the asset. If the then fair market value of the asset is less than the residual that the lessor assumed, the lessor bears this loss.
- The lessee is protected from fair market value fluctuations on any equipment, not necessarily high technology equipment, where the lessor assumes a residual position.
- Technology Refresh – if the lessee chooses to swap the asset for one of newer technology, then the existing lease may be terminated and a new lease initiated.
- Faster tax write-off – as previously mentioned the lease payment is expensed lessening the tax burden on the company. The overall tax burden (over the lease life of the asset) is lessened if the lease term is shorter than the tax depreciation life of the asset.
- Mitigation of Alternative Minimum Tax (AMT) – Cash or bank financed purchases can trigger AMT when depreciation expenses are large enough. Operating leases will not trigger AMT.
- Mid-quarter convention under the Modified Accelerated Cost Recovery System (MACRS) – this convention is triggered if more than 40% of the company’s property is purchased in the fiscal fourth quarter. This condition could result in reducing the amount of MACRS the company can claim. Operating leases will not trigger this convention.
- Faster response time than loans – banks are regulated causing them to be much more cautious. This could cause delays in loan processing. Typically a lessor’s process for approving a lease request is a much simpler process that includes the client completing
a one-page lease application and the lessor performing credit check.
- Faster appropriation from operating budgets – cash or bank financed purchases typically are funded from capital budgets. Approval can be time consuming. Operating leases are typically funded from a pre-approved operating budget.
- Master lease agreements – this makes follow on transactions much easier. The lessee would not need to negotiate new lease contracts when acquiring additional equipment.
- Flexibility at end of term options – lessee can select from following set of options:
* Return the asset
* Purchase the asset
* Renew the lease
Leasing may not always the best option for enterprises. There are situations where outright purchase is the best alternative. However, even if cash purchase is the better option, leasing may still be used to help manage cash flow, for example. Or, instead of using an operating lease, a capital lease may be the best option. In any case, businesses should understand the value of leasing based on their unique requirements.
Leasing can not only help an organization manage its cash flow, leasing can also improve financial reporting by keeping purchases off the balance sheet and improving the income statement. Leasing can also be used as a hedge against advances in technology. A company can use leasing to upgrade new technology on a timely basis. Finally, it is just sometimes more convenient to lease rather than purchase by taking advantage of the speed to process a lease and flexibility of terms within a lease.
When considering the financial aspects of leasing versus purchase, leasing is many times less expensive. The time value of money takes a huge role in determining whether a lease is more advantageous than purchase. Dynamic Funding, Inc. has financial modeling tools that can help evaluate lease versus purchase using your customer’s financial information. It is best that we are involved at the outset of the acquisition process to ensure you have all the right information with respect to leasing.