This is a perplexing question to the entrepreneur and business owner-both big and small.
And it's not to be confused with the decision of whether to lease/finance vs. buy, as this brings up the whole series of questions pertaining to the most effective use of a company's available cash and its effect on the balance sheet.
However, for the sake of this "contrast and compare" outline, we'll assume the "buy option" to be part of the finance decision. When equipment is paid out of cash flow, it is still being financed-just internally-and the true cost involves a complicated "internal-rate-of-return" calculation. But, make no mistake, there is a definite cost.
The pros vs. the cons of whether to lease or finance can be significantly different for companies whose revenues are at opposite ends of the spectrum. This is especially true for larger companies, which often have balance sheet issues vis-à-vis their bank covenants to deal with and possibly the dreaded Alternative Minimum Tax (AMT) to contemplate.
Whereas the freshly minted entrepreneur is more concerned about "just getting financed" with the best possible terms and lowest possible payment using other people's money.
The pros and cons of each can be summed up as follows:
Benefits of Leasing
- One hundred percent of the equipment cost and associated expenses can be financed, including tax, shipping and installation, lowering impact on cashflow and maintaining strong "current assets" on the balance sheet.
- Operating cash is conserved. There is less up-front cash outlay (typically only the first payment is required) which is good for the balance sheet.
- Overall, leasing usually has a lower impact on cash flow due to lower payments and the fact that more of the cash flow (especially the option to buy the equipment) occurs later in the lease term, using cheaper, inflated dollars.
- The business owner can acquire equipment, often without financial disclosure (tax returns/financial statements) of up to $150,000.
- Monthly payment is treated as a business expense on an operating lease and thus provides for 100 percent tax write-off. Payments are fixed for the lease term and are a hedge against inflation.
- Leases are not treated as assets, so they do not appear on the balance sheet, which can improve financial ratios.
- Leases transfer all risk of obsolescence to the lessor, since there is no obligation to buy the equipment at the end. You pay only for the use of the equipment, not the ownership.
- Leasing provides for easier asset management because you are only responsible for the time you are in possession of it. At the end of the lease, the lessor has the responsibility of disposing of the asset, and typically there are very few (if any) restrictions on exotic or specialty equipment.
- The leased asset is typically all that is required to secure the lease transaction. There are no blanket liens.
- Leasing does not adversely impact existing credit lines, which provides additional credit availability and diversification of lenders. This is especially important in times of tight credit and bank lending restrictions because lease payments are fixed for the term and, unlike "demand loans," cannot be "called."
- Flexibility in the lease term and structure is a plus, they often offer ninety days deferred and seasonal payments are available (i.e., no payments required in the winter months).
- Leasing allows the business owner an alternative use of funds when liquidity is critical. Options may include taking large cash, term or quantity discounts off vendors or hiring your competitor's best sales rep. Cash to the entrepreneur is like oxygen-without it, they perish.
Benefits of Financing
- IRS Section 179 (which may be extended for 2009), allowed for up to $250,000 in equipment purchases in 2008 to be depreciated in the year in which they became operational. This tax treatment was more favorable than an operating lease, also the interest is expensed over the term of the loan for an additional bonus.
- There is security in owning "long-lived" equipment because there are no surprises at the end of the lease with large balloon payments, especially with fair market value buy-out options.
- Loan agreements are typically more flexible with early buyouts and there are fewer penalties. Leases are typically non-cancellable but will allow early buyouts, although they are generally more expensive.
- A company with sound cash flow and strong financial statements that is not concerned with impacting credit availability may find the nominal bank financing interest expense to be generally cheaper than the implicit interest in lease financing.
- All soft costs (taxes, installation, shipping charges) related to the acquisition, can be expensed on the profit and loss statement in the month in which they were incurred. This avoids interest carrying cost, if cash flow allows.
- You bear the risk of a depreciating asset but enjoy the upside of equipment that holds its value, which is especially the case for non-technology equipment.
- AMT tax trap is generally only an issue for larger companies that acquire a lot of equipment because depreciation is a "preference item" and is not treated kindly by the IRS.
- The finance option allows a company to add assets to the balance sheet and benefit from the annual depreciation and interest expense tax treatment.
Clearly, there are many things to consider when deciding on whether to lease or finance/buy equipment. However, the decision process can be reduced to: What is the impact and what is most important to me, in these three main areas: cashflow, balance sheet and tax treatment?
It may behoove you to start here, then review some of the pros and cons of each.
Construction Business Owner, March 2009