The process of growing a small business generally involves two kinds of significant financial outlays – working capital investments for operational growth factors like hiring employees and managing overhead increases, and fixed capital investments for the acquisition of equipment and other hard assets.
One of the leading questions that a small business owner faces as her or his business grows, is how to finance the acquisition of new equipment. The two primary options available are to lease the equipment or to purchase it.
Since these decisions impact some of the largest investments a small business will make in its growth, it is critically important to analyze these two options carefully. Here are four keys to evaluate the lease vs. buy decision for your small business and its future capital equipment acquisitions:
1. What type of lease are you considering?
There are many different types of leases, and it is essential to understand which leasing options are available to you. Some of the most common lease configurations include:
- Financial Lease – By far the most common lease, the financial lease (also known as a capital lease) typically provides a financing option to the business that allows the lessee to own the equipment at the end of the process, and mandates payments throughout a fixed term until the point at which ownership reverts from the lessor to the lessee. It also generally requires the lessee to maintain the equipment during the lease term at its own expense.
- Operating Lease – Unlike the financial lease, with the operating lease the lessor maintains ownership of the leased assets or equipment throughout the term of the lease. Therefore you are only purchasing access to the asset, rather than securing future ownership.
- Sale & Leaseback – The sale and leaseback allows a party to sell an asset and then lease it back, thus freeing the asset from its position on the company’s books while at the same time ensuring ongoing access and use.
In addition, you should know whether your lease is a Net Lease or a Gross Lease (in a net lease, the lessee is responsible for maintenance, taxes and insurance, rather than the lessor), and whether it is a Full Payout Lease (in which the lessor recovers the full cost of the asset over the course of the lease term).
2. What types of lessors are available to your business?
Equipment leasing does not have to be provided by the equipment owner to the equipment user. Leasing is a financing arrangement that can be provided to both parties through any number of avenues.
For example, you may be able to secure a lease financing arrangement through your commercial bank, through an insurance company, or by using a finance company that specializes in leasing. In addition, the equipment manufacturer or dealer may provide its own leasing options or financing services, most likely through a wholly-owned subsidiary or via a private-label financing partnership.
3. What are the pros and cons of leasing vs. buying?
Generally speaking, we would all generally assume that if you can buy a piece of equipment outright, then you might lean toward doing it. American culture has a strong disposition toward ownership as a beneficial goal and our business mindset tends to teach us that owning is more secure for a business than leasing.
However, this is not always the case and in fact, flexibility and protection of cash flow may be more essential to the stability of your business than owning a piece of equipment. Here are some key pros and cons of leasing, when compared to buying:
Advantages of Equipment Leasing:
- Leasing typically requires little to no down payment, while an equipment loan typically requires a large down payment (25% or more).
- Does not usually require personal guarantees or other financial restrictions on the company, as a loan may.
- Can spread payments over a longer period of time (which lowers monthly payment amounts).
- Hedges against the risk of equipment becoming obsolete since you are usually in a better position to eliminate, upgrade or replace equipment at the end of a lease.
Disadvantages of Equipment Leasing:
- The economic value of the equipment is lost since you don’t own the asset (unless your arrangement is a lease-to-own conversion). It is not unusual for a small business owner to significantly underestimate the economic value of an asset and therefore choose leasing even when buying may have been more strategic.
- Depending on the terms of the lease, you may find that it is just as restrictive a legal obligation as what you encumber by taking out a loan to purchase the equipment. Most business leases cannot be prematurely cancelled, and it may be the case that even if your circumstances change, the lease remains restrictive and less flexible than you had envisioned.
4. What are the accounting and financing considerations of the lease/buy evaluation?
First, regarding accounting treatment, you should be aware that lease obligations are increasingly being shifted from ‘off balance sheet’ positions to mandatory reporting in a company’s financial statements. Therefore, you should take this into account since it was historically a major reason why some businesses preferred leasing.
Second, there are a number of cost analysis tools and methods you can use to evaluate the lease vs. buy question in detail. The process of performing a cost analysis will take into account factors such as the cost of each alternative; your cash flow position and requirements; anticipated growth plans and related potential drains on cash flow; the timing of the payments; interest rate on a loan vs. lease rate; and other financial considerations and factors.
It is also important that when you perform your lease cost analysis, you make reasoned and evidence-backed assumptions about the expected economic life of the equipment; its operational longevity; anticipated obsolescence; salvage value of the equipment; and depreciation (loss of value). In addition, a common consideration is the comparison of bank loan interest rates to the effective interest the business will pay for a financial lease.
By considering all four of these factors — the types of leases, the types of lessors, the pros and cons of leasing vs. buying and the accounting and financial considerations to be evaluated in a formal lease/buy analysis, you will be well-positioned to make nimble, precise and strategic decisions about the future of your business.
If you are presently considering a capital investment strategy to acquire new assets for your business today, contact your CPA as a next step so that they can advise and guide you through the evaluation and analysis process with a detailed review that meets your business requirements for today, as well as tomorrow.
- Lease Versus Buy Equipment Decision [BizMove]
- Lease vs. Purchase Considerations [Missouri Business Development Program]
- Case Study: Equipment Leasing vs. Purchasing [BizFilings]