When two parties enter into a lease, the user of the asset, known as the lessee, pays the asset’s owner, known as the lessor, in exchange for using the item for a specified amount of time. Typically, the asset consists of equipment, real estate, and cars. Personal, business, or industrial assets may be included. According to local law, a lease is typically a binding legal contract between the parties.
Leasing is slightly different from renting. In the case of a lease, the owner (lessor) of the asset gives the possession and ownership (subject to conditions) of the asset to the user (lessee) for a certain period. However, when an asset is rented, the ownership remains with the lessor, just the possession is transferred to the lessee, with conditions and for a mutually agreed period.
Broadly, leases are classified into two types:
Finance lease or capital lease
Operating lease
What is a Finance Lease (Meaning)?
A Finance Lease is a type of lease in which the lessee (user) has operating control of the asset for the duration of the lease. At the end of the lease period, the lessee (user) becomes the asset owner by paying a certain amount. In short, in the case of a finance lease, the asset’s acquisition cost is spread over the life of the lease. Over the lease period, the financial risks and rewards will be shared by both parties in varying degrees as per the lease agreement.
In the case of a finance lease, the customer (user) zeroes in on the desired asset. The finance company then purchases the asset, including the cost of the asset and interest. The customer starts paying a fixed amount periodically (mostly monthly) to the leasing company for using the asset. Once the lease period is over and all payments have been made, the user has the option to buy (take ownership of) the asset.
There are several advantages of a finance lease.
Companies that do not want to commit heavy upfront payments, can use a finance lease to systematically acquire (own) an asset.
The owner (lessor) gets tax benefits for income suppression on account of depreciation.
Similarly, the user (lessee) can claim tax benefits by deducting tax payments as expenses.
The lessor is also guaranteed a steady income by way of monthly rental payments received from the user (lessee).
The user (lessee) is protected against inflation, since the price of an asset for the lessee remains unchanged throughout the lease period, irrespective of inflationary effects in the economy.
What is an Operating Lease (Meaning)?
An Operating Lease is one in which the user (lessee) uses the asset for the lease period, but does not, in any way, assume ownership rights of the asset. Thus, the user incurs relatively lower expenses for using the asset but does not incur heavy expenses needed for buying the same. Since the user (lessee) does not intend to buy the asset, it is not shown on the lessee’s balance sheet, thereby allowing for a leaner balance sheet and a lower debt-equity ratio. As a result, an operating lease is considered to be off-balance sheet financing.
There are several advantages of an Operating Lease.
Since the user (lessee) is not looking to own the asset, the financial consideration for the lessee is lower. This is good for businesses that are smaller in size or those that are looking to lease the asset for a short period.
The lessee does not have to pay for repairs and maintenance of the asset.
If you fear that technological advances could make your equipment obsolete within a few years, an operating lease provides you with a great way to use the equipment for a limited period and then move on.
Payments made towards servicing the lease can be deducted as operating expenses for tax calculation.
Difference between Finance Lease and Operating Lease
| Finance Lease | Operating Lease | |
| Tenure | Long term | Short term |
| Ownership | Generally gets transferred to the user (lessee) at the end of the lease | Remains with the owner (lessor) throughout |
| Responsibility of maintenance | Lessee needs to maintain | Lessor needs to maintain |
| Option to purchase the asset | The lessee is given this option at the end of the lease | Lessee is not given the option to purchase the asset |
| Balance sheet impact | The asset appears on the balance sheet of the user (lessee) | The asset is not shown on the lessee’s balance sheet |
| Lease term | Most of the useful economic life of the asset | Less than 75% of the projected useful life of the asset |
Which type of lease is best for your business?
The type of lease to be used depends on factors such as the type of business, the operating environment, the financial condition of the business, etc. There is no simple answer to this question, and it depends on a host of factors.
If you wish to own an asset but without the burden of high upfront payment, you can go in for a finance lease. On the other hand, if you just need to use the asset for a short time without getting into the hassle of ownership, you can go in for an operating lease.
With ownership comes the hassle of repairs and maintenance of the asset. In an operating lease, you are just leasing the asset for your use, hence you do not have to get into the repairs and maintenance. That is handled by the lessor.
If you are looking at having a leaner balance sheet, an operating lease might suit you.
Hence, it is clear that the type of lease you need to enter depends on your requirement. It differs from business to business and circumstance to circumstance.
Another option for leasing is buying, which involves an upfront payment to acquire the asset.
Conclusion
Whether you decide to buy or lease, always remember that you need to use your financial resources wisely. If you have any funding requirements, you can always borrow funds from a good lender like Credit Success. The biggest advantage of a good lender is that you need not worry about sky-high interest rates, hidden charges, quality of customer service and speed of approvals.
Frequently Asked Questions
What is a finance lease with an example?
A finance lease is one in which the user assumes operating control of the asset during the term of the lease and ownership of the asset at the end of the lease period.
Example – The estimated useful life of machinery is 5 years, and the lease period is 4 years. At current valuations, the fair value of the machinery is Rs.10 Crore, while the present value of lease payments is Rs.9.5 Crore. This is an example of a finance lease because it satisfies both the conditions of a finance lease. Firstly, the lease period is at least 75% of the estimated useful life of the machinery (4/5 = 80%). Secondly, the present value of lease payments is at least 90% of the fair value of the machinery (9.5 / 10 = 95%).
What is the difference between a finance lease and an operating lease?
Refer to the table above for finance lease vs operating lease
Which is Better: Finance or Operating Lease?
There is no “better” type of lease. The type of lease you need to use depends on your requirement, financial position, the time for which you need the asset and so on. Both operating and finance lease have their advantages under specific circumstances.
Are capital leases now called finance leases?
Capital leases and finance leases both terms are used interchangeably.
