Leasing is becoming a preferred solution to resolve fixed asset requirements vs. purchasing the asset. While evaluating this investment, it is essential for the owner of the capital to understand whether leasing would yield better returns on capital or not. Let us have a look at the advantages vs disadvantages of leasing.
What is a lease or leasing?
A famous quote by Donald B. Grant says,
“Why own a cow when the milk is so cheap? All you really need is milk and not the cow.”
The concept of a lease is influenced by this quote. We can compare ‘milk’ with the ‘rights to use an asset’ and ‘cow’ with the ‘asset’ itself. Ultimately, a person who wants to manufacture a product using machinery can get to use that machinery under a leasing arrangement without owning it.
A lease can be defined as an arrangement between the lessor (owner of the asset) and the lessee (user of the asset) whereby the lessor purchases an asset for the lessee and allows him to use it in exchange for periodical payments called lease rentals or minimum lease payments (MLP). Leasing is beneficial to both parties for availing tax benefits and doing tax planning.
At the conclusion of the lease period, the asset goes back to the lessor (the owner).
There are 3 different things possible post-termination of the lease agreement.
- The lease is renewed by the lessee.
- The asset comes back to the lessor and he sells it off to a third party.
- Lessor sells to the lessee.
What is the purpose of leasing?
The purpose of choosing a lease can be many. Generally, a lease is structured for the following reasons:
- Benefits of taxes
The tax benefit is availed to both the parties, i.e., Lessor and Lessee. Lessor, being the owner of the asset, can claim depreciation as an expense in his books and therefore get the tax benefit. On the other hand, the lessee can claim the non-financial element of the lease rentals as an expense and achieve tax benefits in a similar way.
- Avoid ownership and thereby avoid risks of ownership
Ownership is averted to avoid the investment of money into the asset. It indirectly keeps the leverage low and hence opportunities for borrowing money remain open for the business. A lease is an off-balance sheet item.
7 Advantages of leasing:
1) Balanced cash outflow
- Balanced cash outflow
The biggest advantage of leasing is that cash outflow or payments related to leasing are spread out over several years, hence saving the burden of one-time significant cash payments. This helps a business to maintain a steady cash-flow profile.
- Quality assets
While leasing an asset, the ownership of the asset still lies with the lessor whereas the lessee just pays the rental expense. Given this agreement, it becomes plausible for a business to invest in good-quality assets which might look unaffordable or expensive otherwise.
- Better usage of capital
Given that a company chooses to lease over investing in an asset by purchasing, it releases capital for the business to fund its other capital needs or to save money for a better capital investment decision.
- Tax benefit
Leasing expenses or lease payments are considered operating expenses, and hence, of interest, are tax deductible.
- Off-balance sheet debt
Although lease expenses get the same treatment as that of interest expenses, the lease itself is treated differently from debt. Leasing is classified as an off-balance sheet debt and doesn’t appear on the company’s balance sheet.
- Better budgeting and planning
Lease expenses usually remain constant for over the asset’s life or lease tenor or grow in line with inflation. This helps in planning expenses or cash outflow when undertaking a budgeting exercise.
- Low capital expenditure
Leasing is an ideal option for a newly set-up business given that it means lower initial cost and lower Capex requirements.
Disadvantages of leasing:
- Lease expenses
Lease payments are treated as expenses rather than as equity payments towards an asset.
- Limited financial benefits
If paying lease payments towards land, the business cannot benefit from any appreciation in the value of the land. The long-term lease agreement also remains a burden on the business as the agreement is locked and the expenses for several years are fixed. In a case when the use of assets does not serve the requirement after some years, lease payments become a burden.
- Reduced return for equity holders
Given that lease expenses reduce the net income without any appreciation in value, it means limited returns or reduced returns for an equity shareholder. In such a case, the objective of wealth maximization for shareholders is not achieved.
- Debt
Although a lease does not appear on the balance sheet of a company, investors still consider a long-term lease as debt and adjust their valuation of a business to include leases.
- Limited access to other loans
Given that investors treat long-term leases as debt, it might become difficult for a business to tap capital markets and raise further loans or other forms of debt from the market.
- Processing and documentation
Overall, entering into a lease agreement is a complex process and requires thorough documentation and proper examination of an asset being leased.
- No ownership
At the end of the leasing period, the lessee does not end up becoming the owner of the asset though quite a good sum of payment is being done over the years towards the asset.
- Maintenance of the asset
The lessee remains responsible for the maintenance and proper operation of the asset being leased.
- Limited tax benefit
For a new start-up, the tax expense is likely to be minimal. In these circumstances, there is no added tax advantage that can be derived from leasing expenses.
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