A lease is in essence an extended rental agreement wherein the owner of the equipment (the lessor) allows the user (the lessee) to operate or otherwise make use of the equipment in exchange for periodic lease payments. "There are a number of reasons that companies sometimes prefer to lease equipment rather than buying it," said Richard A. Brealey and Stewart C. Myers in Principles of Corporate Finance. "For example, there may be good tax reasons. If the operator cannot use the depreciation tax shield, it makes sense to sell the equipment to someone who can. Also, the lessor may be better able to bear the risk of obsolescence, or be in a better position to resell secondhand assets. The lessor may be able to offer a very good deal on maintenance. Finally, it may be much less costly in time and effort to arrange a simple lease contract on a standard item of equipment than to arrange a normal loan."
Equipment leasing is a popular option for companies of all sizes. The Equipment Leasing Assocation of America estimates that 80 percent of all companies lease at least some of their equipment, and the organization estimates that firms leased $226 billion worth of goods in 1999. But equipment leasing is particularly favored by many small businesses, which often have future options because of limited capital. "The practice of leasing equipment as a way to make the most efficient use of resources—particularly in times of tight credit—is found in a variety of industries," pointed out Jack Wynn in Nation's Business. "One of the major categories of leased equipment consists of high-technology items such as computers, telecommunications equipment, and diagnostic tools. Another category is low-tech capital equipment, from office equipment and materials-handling machinery to marine cargo containers, trucks, trailers, rail cars, forklifts, and cranes." Finally, lease agreements are popular because they often contain provisions that allow the lessee to purchase the item at the end of the lease period if they so desire.
The two primary types of leases are operating leases and long-term leases. Operating leases are characterized by short-term, cancelable terms, and the lessor bears the risk of obsolescence. These leases are generally preferable when the company needing the equipment needs it only for a short period of time. Under the usual terms of such agreements, a lessee can usually cancel an operating lease, assuming prior notice, without a major penalty. Long-term, noncancelable leases, which are also known as capital, full payout, or financial leases, are sources of financing for assets the lessee company wants to acquire and use for longer periods of time. Most financial leases are net leases, meaning that the lessee is responsible for maintaining and insuring the asset and paying all property taxes, if applicable. Financial leases are often used by businesses for expensive capital equipment.
In addition to these two basic leasing models, there are a considerable variety of other lease arrangements that are often used. These leases, each of which combine different financial and tax advantages, are actually hybrids of financial and operating leases that reflect the individual needs of lessor companies. For example, full-service leases are leases wherein the lessor is responsible for insurance and maintenance (these are commonplace with office equipment or vehicle leases). Net leases, on the other hand, are leases wherein the lessee is responsible for maintenance and insurance. Leveraged leases, meanwhile, are arrangements wherein the cost of the leased asset is financed by issuing debt and equity claims against the asset and future lease payments.
Small business experts caution prospective lessees to keep in mind that lease rates can vary considerably from lease company to lease company. Lease companies also may charge different rates for the same piece of equipment, depending on various characteristics of the business that is seeking the lease. Factors that can impact the lease rate include the credit history of the lessee, the nature of equipment wanted by the lessee, the length of the lease term, and whether the lessee or lessor is the primary beneficiary of tax credits associated with the transaction.
Writing in The Entrepreneur and Small Business Problem Solver, William A. Cohen delineated ten major terms of most equipment leasing contracts:
There are several characteristics of equipment leasing that can be advantageous to small business owners. They include the following:
CONVENIENCE In instances where a company only needs a piece of equipment for a limited period of time, short-term leases can be most convenient. Rather than go to the trouble of negotiating purchase, arranging insurance and registration, negotiating resale, and canceling insurance and registration, a business can simply rent the item for the duration of time needed. "Sometimes the cost of short term rentals may seem prohibitively high, or you may find it difficult to rent at any price," wrote Brealey and Myers. "This can happen for equipment that is easily damaged by careless use. The owner knows that short-term users are unlikely to take the same care they would with their own equipment."
FLEXIBLE FINANCING TERMS As Jack Wynn stated in Nation's Business, some lease arrangements are structured so that 100-percent financing is available. "Although payments for a lease may be somewhat higher than those for a conventional loan, there is no down payment, which helps preserve the lessee's operating capital and borrowing capacity. Similarly, leasing is an 'off the balance sheet' form of financing that is considered an operating expense, not a liability. This allows companies to acquire equipment without the acquisition affecting their capital budget. And lease payments usually can be spread over a longer period of time than the one to three years customary for bank loans."
CANCELLATION OPTIONS Some lease agreements provide lessees with cancellation options in the event that the equipment proves inadequate for the company's needs over the course of the agreement. Upgrades are sometimes available through these options. One vital category of equipment that often includes such an option is computer systems. "Computers are frequently leased on a short-term cancelable basis," stated Brealey and Myers. "It is difficult to estimate how rapidly such equipment will become obsolete, because the technology of computers is advancing rapidly and somewhat unpredictably. Leasing with an option to cancel passes the risk of premature obsolescence from the user to the lessor. Usually the lessor is a computer manufacturer or a computer leasing specialist, and therefore knows more about the risks of obsolescence than the user. Thus the lessor is better equipped than the user to bear these risks." A lease agreement equipped with a cancellation option may be more expensive than one that is not so adorned, but many small business consultants contend that the added security is worth the additional expense.
TAX BENEFITS Under so-called "tax leases," the lessor owns the equipment for tax-reporting purposes. "In a tax lease, the lessee is 'trading' the tax benefits of equipment ownership with the lessor for favorable payments and more flexible tax management," noted Deborah Borow in Business First of Buffalo. "Depending on the lessee's specific tax situation, this lease feature can significantly lower the total cost of equipment."
Synthetic leases, meanwhile, are structured as a loan for tax purposes but as a lease for accounting purposes. "It allows corporations to acquire assets that are financed off the balance sheet while retaining the tax benefits of ownership," said Borow.
MAINTENANCE This option generally results in higher lease payments, but it is often money well-spent for small companies with limited financial and workforce resources. Under the terms of full-service leases, the lessor is responsible for all maintenance associated with the equipment being leased.
SPEED Businesses in need of securing equipment quickly often find leases to be preferable. Purchases requiring business loans, on the other hand, often take a week or more to complete.
Business consultants and long-time equipment lessees agree that leasing companies vary considerably in terms of product quality, leasing terms, and customer service. Small business owners should approach a number of lease companies if possible to inquire about lease terms. They should then carefully study the terms of each outfit's lease agreements, and check into the reputation of each company (present and former customers and agencies like the Better Business Bureau can be helpful in this regard).
Finally, it is also important for entrepreneurs and business owners to take today's fast-changing technology into account when considering an equipment leasing arrangement. "Because rapidly changing technology can cause an asset to become obsolete before it wears out or the lease expires, you will want to be sure the provisions of your lease permit exchanges for more advanced equipment or replacements, as they become necessary," stated Borow.
Borow, Deborah. "Leasing Equipment Might Pay Dividends." Business First of Buffalo. August 14, 2000.
Brealey, Richard A., and Stewart C. Myers. Principles of Corporate Finance. 4th ed. New York: McGraw-Hill, 1991.
Cohen, William A. The Entrepreneur and Small Business Problem Solver. 2d ed. New York: Wiley, 1990.
"Equipment Leasing: Business Vs. Rental Status." Journal of Accountancy. March 1993.
Gallinger, Jason. "The Joys of Nonownership." Pittsburgh Business Times. September 8, 2000.
Klinger, Linda. "Equipment Leasing: Money Saver or Waster?" Washington Business Journal. May 5, 2000.
Wynn, Jack. "To Use but Not to Own." Nation's Business. January 1991.
SEE ALSO: Automobile Leasing