Financing an Asset

Overview

Paying cash for an asset can significantly drain your working capital. Leasing an asset, however, gives you access to the asset without paying for it all at once. Leasing is basically a rental agreement giving you (the lessee) the right to use an asset owned by the lessor (finance company) for a period of time. In return you make regular payments.
You can lease virtually anything, equipment valued at a few thousand pounds to assets worth millions. Leasing contracts are flexible, usually tailored to your needs and the life expectancy of the asset.
When leasing, consider its effects on accounting, reporting, tax, and your cash flow. This section will give you a general overview. It does not replace professional advice. You may wish to consult your accountant before finalising any lease arrangement to ensure the maximum benefit and avoid complications.

How It Works

Inside of a factory There are many types of leasing but, fundamentally, all fit one of two categories:

Direct Lease. You identify the asset, agree the price and arrange for the leasing company to buy it and rent it to you.
Sale-and-leaseback (also called sale and leaseback). You sell an asset you already own to the leasing company and then lease it back.

The lessor owns the asset and rents it to you. You return the asset at the end of the lease to the lessor. Some leases grant you an end-of-lease option to renew the lease or to sell the asset to a third party as agent of the lessor.

Types of Asset Finance

There are three major types of leasing: We have also included hire purchase in the following:

Finance Leasing (Full Payout Lease). You get all the financial benefits and risks without actually acquiring legal title. The leasing rate collects full value of the asset (plus finance charges) over contract period. At Lease end, asset is sold to a third party and you can receive a share of sale proceeds (if the lease is not being extended). Generally, you will not be able to become the owner of the asset at any time - unless a private arrangement is made with the third party. You usually have the option to extend the lease and as you have paid for almost the full value during your initial lease period, the rental payments for subsequent periods will be minimal
Operating Lease. Often shorter time frame than financial leasing (always significantly shorter than the asset working life), operating leasing is more like regular rental. The lessor expects to be able to sell the asset in the second-hand market or to lease it again and will therefore not need to recover the total asset value via lease payments. There may be an option to extend the leasing period at the end (negotiation can only take place at the end of the initial rental period). As with finance leases, you will not be able to become owner of the asset at any time but, contrary to financial leases, you will not share in the sale proceeds.
Contract Hire. A form of operating lease (often used with cars/vehicles). Includes number of additional services, maintenance, management or replacement if in repair.
Hire Purchase. Agreement to hire an asset with option to purchase. Legal title will pass to you when all payments made. Term must be significantly shorter than asset working life. You can claim capital allowances as if you purchased the asset outright, gaining immediate use of it. Hire Purchase agreements are typically for domestic users, not so much for business users.

End of Lease Options

At the end of the lease term, you have various options. Lease contracts can stipulate that you

return the asset;
have the right to act as an agent to sell the asset to an independent third party; and/or
could renew the contract or enter into secondary periods.

It is important for you to anticipate future needs as each has 'pros and cons' and affect the monthly payments.

Choosing the Right Type of Finance

There are different advantages, it is important you assess your circumstances/needs before committing.

For example, if you

want to own the asset straight away, an outright purchase (cash or loan/overdraft) might be appropriate;
may want to own the asset at some point in time and want to take advantage of instalment payments, hire purchase might be the best option;
do not want to own the asset at all but require it for most of its useful life, consider a financial lease; and
require the asset for a period of time significantly shorter than the useful life of it, consider an operating lease.

Advantages

Better Cash Flow. Gives you access to the asset, minimal up-front payments and spreads the cost. Pay for the asset with the income it generates minimising drain on working capital.
No debt. Operating lease preserves your credit options and does not influence your credit limit. It is generally not classified as debt but as an expense (note : advantage does not apply to finance leases!).
Maximise Financial Leverage. Lease can often finance everything related to the purchase/installation of the asset it may free up cash flow to fund items such as training.
Simplified cash flow management. Lease payments usually flat, cash management is predictable/easier than with variable rate loan. Fixed interest rate helps if interest rates rise.
Tax advantage. Operating lease payments generally tax deductible like depreciation charges but made with pre-tax money. Cash purchases, in contrast, made with after-tax money. Hire purchase agreements allow the lessee to claim capital allowances.
Flexible time frames. Leasing contracts can be structured to fit your requirements. Use an asset as long as you need it without owning it forever.
Hedge against obsolescence. Return the asset to the lessor. No hassle of selling the used asset or running the risks related to residual value and (technical) obsolescence.
Additional advantages. Some leases offer additional advantages such as cancellation options or asset maintenance.

Disadvantages

More expensive. Can be more expensive than outright purchase as payments include finance charge. However, leasing may cost less than other forms of financing. Consider the tax advantages when making this calculation.
Additional Guarantees. Depending on your company credit rating, lessor may require additional guarantees. These may be provided by you, your partners or your bank and could affect your personal credit rating or your standing with your bank.
Fixed Term. Usually impossible, or costly, to terminate a leasing contract early.
Fixed Interest Rates. Interest rates are usually fixed throughout the lease which may prove a disadvantage in times of falling interest rates.

Things to Watch out for:

Return of Asset Conditions. Condition and place where it must be returned are important aspects to consider.
Notice Period. Option to renew, note notice periods in case you do not want to renew the contract. Lessor may automatically renew the contract if you fail to give notice.
Purchase Rights. If negotiating the right to purchase the asset at the end of your lease, a predetermined fixed price offers more value as the 'fair market value', which theoretically is always available to you.
Maintenance Responsibility. Clarify service or maintenance programs in the lease. If you are responsible for service and maintenance, make sure it is not too onerous.

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