Within the past decade, equipment leasing has mushroomed into a multi-billion dollar industry and currently accounts for over one-quarter of all capital expenditures in the United States.
There are five major reasons, or category of reasons why lessees prefer equipment leasing versus a loan for equipment acquisitions.
1) Economic or Financial
2) Financial Reporting
3) Income Taxes
4) Technological
5) Flexibility
Let's examine each of these more closely.
1) Economical. The economic attributes of an equipment lease can be considerable. The monthly rentals in the lease can be quite low when compared to the loan payments levied by a bank, due primarily to the impact of the residual value in a lease.
The tax benefits alone that are generated in the transaction will influence the lease payments as well. The lessor can lower the equipment lease payments when receiving value from tax benefits, although, the lessor may use tax benefits to increase its yield.
Longer lease terms also help to lower the lessee's lease payments. The repayment of the equipment cost is spread out over more periods so less payment needs to be charged each period to recover the entire cost.
Equipment leasing also requires little, if any, up-front cash outlays when compared to a bank loan. Many leases require just one payment up front versus the normal down payment requirement on an installment loan for a lessee with a good credit history. The combination of lower up-front and lower subsequent payments helps to preserve working capital.
Additionally, equipment leasing provides the business owner with another source financing, thus allowing them to diversify their funding options.
2) Financial Reporting. Entities are constantly striving to have their financial statement look as strong and healthy as possible to their shareholders and lenders. When a company purchases equipment and finances it with a loan, an asset, as well as the corresponding liability, appears on the balance sheet. If, however, the company chooses equipment leasing over a loan, and that lease is classified as an operating lease, then no asset or liability would appear on the company balance sheet. Hence, the term operating lease has become synonymous with off-balance-sheet financing.
Off-Balance-Sheet financing is sought after for a variety of reasons: to keep debt off the balance sheet, to improve the financial ratios of a company, and to potentially enhance the company's ability to borrow in the future. It is also conceivable that in the early years of the lease, the operating lease will improve the company's reported earnings when compared to a capital lease or purchase.
3) Income Taxes. The value of tax benefits to the lessor can influence the lease payment charged to the lessee. A built-in reciprocity exists in tax leasing, in that the lessor-owner in a tax lease receives the tax benefits given up by the lessee-user and, in return, may pass those benefits on to the lessee in the form of a lower lease payment. The lessee also receives a tax benefit since the lease payments are fully deductible.
Another income tax factor to consider is the Alternative Minimum Tax or AMT, which is very complex. AMT is a penalty tax imposed by Congress. Equipment leasing, not purchasing, helps an organization avoid falling into this penalty situation, thereby saving taxes.
4) Technological. In today's rapidly changing environment, there is always the risk that high technology equipment will become obsolete. Indeed, the risk of technological obsolescence is one of the primary reasons for leasing. Equipment leasing can help lessees transfer the risk of owning equipment which is no longer technologically useful.
The transfer of risk can be accomplished in several ways. The most obvious would be for a lessee to enter into a short-term agreement, thereby requiring the lessor to assume the technological risk through residual value. If the equipment is still useful at the end of the lease term, the lessee could then renew the lease. If the equipment becomes obsolete during the lease term, the lessor may replace it with newer technology through what is know as a takeout, or an equipment upgrade.
In a takeout, the lessor, through its access to the secondary market, will find a new home for the original equipment because equipment that is obsolete to one entity is not necessarily obsolete to another. For new and untried technology, many lessees prefer leasing the equipment on a short-term or experimental-use basis.
5) Flexibility. A company may simply need the use, not the ownership, of a piece of equipment. Leasing can help a company avoid many of the headaches associated with equipment ownership. For instance, leasing can transfer the burden of disposing of the equipment o the lessor, who typically has better access to the used equipment market. The lessee can also contract with the lessor to take care of the other aspects of ownership, such as insurance, maintenance and property tax, by bundling these costs into the lease payment. Many lessees appreciate this one-stop shopping aspect of equipment leasing.
Many owners/managers prefer equipment leasing, as opposed to purchasing, because leasing enables them to acquire needed equipment out of their operating budgets, without the necessity of going through a lengthy bureaucratic capital budgeting and approval process. Lessees may also benefit from very flexible structuring practices such as step or skipped-payment leases. These type of payment schedules are useful to businesses in industries that are seasonal and disruptive to cashflow.
Note: Business owners should always seek advice from their tax professionals before a major equipment acquisition.
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