Benefits and Pitfalls of Leasing

There are many advantages to leasing equipment vs. paying cash or bank financing.

Some people incorrectly view leasing as "last-resort" or expensive financing for start-ups. The truth of the matter is that bank financing is often more expensive than lease financing (click to read why) and getting any type of funding for a start-up typically comes at a higher cost because there is more risk.

The vast majority of successful companies are using some form of lease financing as a business procurement tool.

Before entering into a leasing agreement it is important to understand two things:

  1. Lease financing is utilized by most of the Fortune 500® companies to acquire equipment or software.
  2. The leasing industry is unregulated: Let the buyer beware.  (Just because most successful companies do choose to lease equipment, you still need to do your due diligence and ensure that you are dealing with a reputable lessor.)

Since the largest and most successful companies in the world are leasing equipment, simple logic dictates that it may in fact make good business sense for the small and mid-size companies to also consider leasing as an alternative to bank financing or paying cash for their equipment acquisitions.  After all, these companies that are utilizing leasing as an effective business tool are the same companies that pay the highest salaries and consulting fees in order to receive the absolute best financial and managerial advice. 

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Leasing Has its Advantages

Equipment leasing serves as a financing vehicle similar to a bank loan.  However, depending on how a lease is structured, there are several key advantages to leasing over bank financing:

  1. A lease can be structured where neither the lease asset nor the lease liability is reported on the Balance Sheet.  Accordingly, leasing can be a form of “Off-Balance-Sheet Financing” which means there are specific tax and financial advantages to be gained by lessees:
    • Net Operating Asset Turnover (NOAT) is higher because reported operating assets are lower while revenues are unaffected.
    • The portion of Return On Equity (ROE) derived from operating activities (Return on Net Operating Assets; RNOA) appears higher, which improves the perceived quality of the company’s ROE.
    • Since lease liability is not reported on the Balance Sheet, the Balance Sheet measure of financial leverage is improved (total Liabilities-To-Equity ratio.)  Many business managers insist that this improved financial leverage results in better credit ratings and, ultimately, lower interest rates on borrowed funds.
    • Lease payments may be 100% tax deductible and considered “rent expense.”
  2. A lease can have variable payments to match a lessee’s seasonal cash inflows or have graduated payments for business ramp-ups or fluctuating cash flows.

  3. Leases usually only require minimum initial payments such as first and last payments in advance.  Bank financing will typically only cover 70-80% of the asset value.  For a sixty-month lease, this equates to +/-3% up front compared to 20-30% equity up front on bank loans.  (For stronger credits, Leases can often be structured with 0% down.)

  4. During the early years of the lease term, rent expense reported for a lease is less than the depreciation and interest expense reported for a loan.  Therefore, Leasing increases Net Income during the early years of the lease.  If the company is growing and continues to add operating lease assets, the level of profits continues to remain higher during the growth period.

  5. If the lessee is entering into a capital lease (such as $1.00 out lease financing); the lessee will have all the depreciation benefits of capitalizing the equipment and any Section 179 benefits – similar to if the equipment were purchased outright or financed through the bank.

Leasing vs. Paying Cash

Not only does leasing offer advantages over bank financing, leasing offers advantages over paying cash for equipment. 

It is a fact that revenues are created through the use of equipment; not through the ownership of equipment.  Many successful business managers point out that it doesn’t make good business sense to use up cash for equipment purchases.  They claim that paying cash for equipment is akin to paying several years worth of employee wages in advance.  (Why pay for something upfront when you are not going to receive the full benefit until later?)

Spending cash on equipment significantly reduces Working Capital (Net Working Capital = Current Assets less Current Liabilities).  Using cash for equipment purchases could potentially have an adverse effect on a company’s finances because less cash means the company is less liquid.  Working capital is the “life-blood” of any business and is the most crucial component of a firm’s success.

Many business managers believe that using cash to purchase equipment is in fact more expensive than leasing.  Take for example a new machine costing $100,000.  Assuming the company is in the 40% tax bracket, a company must first earn $166,666 (pre-tax) in order to afford the purchase.

To lease that same piece of equipment, it might cost $2,240 per month (pre-tax) over the course of 48 months.  Total pre-tax leasing payments therefore equal $107,520 spread over the course of 48 months compared with $166,666 upfront for cash purchase.  “After tax” cost for cash purchase is $100,000 while “after tax” cost of the lease spread out over the 4-year term is only $64,512. 

By now you might be asking “What should my company do with all the cash we were able to keep in Working Capital by leasing our equipment instead of outright purchasing?”  Working Capital should be preserved for meeting the operational needs of the business.  Utilize your cash for such discounts for monthly inventory purchases, parts purchases and raw materials purchases. 

Let’s suppose that you (1) preserve cash as Working Capital to pay for these types of purchases (and do not have to borrow from a Bank line of credit because you didn’t tie your cash up in equipment) and (2) that you are able to negotiate a 1½% discount for prompt payment of each invoice:  The result would be that you end up earning 18% per year on your Working Capital simply by discounting invoices.  At the same time, you would eliminate the bank fees that you are charged when you draw down on your line of credit (because the line of credit is no longer needed.)


Choose Your Leasing Partner Wisely

So you’ve decided to consider leasing your next equipment acquisition.  What next?

Pricing is important.  But remember, it is only part of the equation and therefore a portion of the overall value equation.

Here are some things that we recommend you consider when choosing a leasing option and leasing partner:

  1. Can you define the actual deal?

    In other words, what happens at the beginning, middle and end of the lease?  Does your firm automatically own the equipment?  Is there a buyout?  Is the buyout defined?  If the lease is “open-ended,” what are your options at the end of the lease term?  What happens if you don’t exercise any options?  Does this put you in a situation where you could have more obligations that don’t make the best business sense?

  2. How well do you know the firm you are dealing with?  Can they offer references with other firms similar to your company?
  3. Is your leasing company’s documentation fair and current? 
  4. Does your leasing company have the ability to fund internally?  Are you dealing with a lessor or a broker?  If your leasing company follows a syndication model, what happens to your deal if it is sold into the market?
  5. Once the deal is closed, if you have a servicing or billing issue – or a simple question, what steps will you have to take to get the question answered?  Is help a simple phone call away or do you have to enter the magical mystery voice mail maze?
  6. Who will handle the billing and collecting?
  7. How flexible is your leasing partner?  What happens if you want to upgrade the leased equipment midway through the lease?  Will your leasing partner work with you?
  8. Ask the individual that you are dealing with (a) how long they’ve been in the leasing business, (b) how long they’ve been with the leasing firm, and (c) why and how they came to work for their employer.
  9. Find out what the processes are for credit approval and how those decisions are made.

Business is about relationships.  Do you really want to have a relationship with the leasing company you are talking to?  Remember that when you enter into a lease, you are hiring the leasing company for at least the duration of the lease.

Will they be a good hire?  Do you know who you are hiring?  Why did you choose the leasing partner that you did?

There are many reputable leasing and finance companies out there.  Make sure you find one.  We recommend that, at the very least, the leasing partner that you choose to work with is a member of the Equipment Leasing and Finance Association (ELFA).