Sooner or later, every small company needs access to tangible assets -- such as equipment, real estate, or vehicles -- to conduct business. Should you lease or buy these assets? The answer will likely depend on several factors, including cost, your cash flow, tax issues, your future need for credit, the importance of owning (vs. using) the asset, and the asset's expected long-term value.
Understanding the Big Picture
Leasing and buying are alternate ways of financing access to an asset. When you buy an asset, you typically pay cash or obtain a loan and assume ownership. Owning an asset enables you to build equity and control how the asset is used. On the downside, you assume all potential risk, including the possibility that the asset could become obsolete or its value could decline.
When leasing, you usually sign a contract with a lessor -- such as a manufacturer, leasing company, or financial institution -- that maintains ownership of the asset. The contract specifies how you can use the asset, the term of the lease, required payments, and circumstances associated with termination. Depending on the terms of the contract, you may assume ownership, turn the asset back to the lessor, or lease a new asset when the contract expires.
Leasing typically entails lower upfront and ongoing costs. Leases do not require collateral or down payments and, because you pay only for the value to be depleted during the term of the lease, your periodic payments are likely to be less than those associated with a loan, where you assume total cost of ownership. The potential savings could enable you to deploy cash to other business needs or potentially lease a larger and more valuable asset.
Keep in mind, however, that leasing could cost more than owning if you violate terms of the contract. For example, vehicle leases may impose financial penalties if you exceed mileage allowances or the vehicle experiences excess wear and tear. Also, most leases require penalties for early termination.
Taxes and Financial Statements
From a tax standpoint, both buying and leasing offer potential advantages. When you own an asset, you can depreciate its value on your federal tax return, usually over a period of between five and seven years. Lease payments cannot be depreciated but they can be expensed which results in lower taxable income.
Leasing and buying also have different implications for your balance sheet. Because an operating lease is not considered a long-term debt or liability, it does not impact your financial statements. In contrast, an owned asset appears on your balance sheet with a corresponding liability. This can affect your financial ratios and, ultimately, your ability to obtain a loan from a financial institution. Consult a qualified accounting professional for more information on the benefits and/or tradeoffs of leasing vs. buying.
Capturing Residual Value
Before making your buy or lease decision, determine the asset's potential future worth. If the asset declines in value, you may be able to "walk away" from it at the end of a lease agreement. By contrast, you are responsible for disposing of an asset you own, which could be difficult if it has little residual value. When an asset appreciates, you capture the benefit when you own it. If you lease it, you may be required to make a predetermined payment if you want to purchase the asset at the end of the contract.
Before You Sign
If you are considering a lease, the Equipment Leasing Association recommends asking yourself the following questions before making a financial commitment:¹
- How am I planning to use this equipment?
- Does the leasing representative understand my business and how this transaction helps me to do business?
- What is the total lease payment, and are there any other costs that I could incur before the lease ends?
- What happens if I want to change this lease or end the lease early?
- How am I responsible if the equipment is damaged or destroyed?
- What are my obligations for the equipment (such as insurance, taxes, and maintenance) during the lease?
- Can I upgrade the equipment or add equipment under this lease?
- What are my options at the end of the lease?
- What are the procedures I must follow if I choose to return the equipment?
- Are there any extra costs at the end of the lease?
Deciding whether to lease or buy an asset requires considerable research on cost issues. If you make the right decision, you are likely to manage your assets efficiently while keeping your costs under control.
Points to Remember
- When you buy an asset, you typically pay cash or obtain a loan and have the right to use the asset at your discretion. With a lease, a manufacturer or leasing company typically retains ownership and you use the asset for the term of the contract.
- Leases do not require down payments, and payments are likely to be less than those associated with a loan. Leases may contain clauses that trigger financial penalties under certain circumstances, such as early termination.
- Owned assets can be depreciated on your federal tax return. Leased assets cannot be depreciated but lease payments can be expensed, which may reduce your taxable income.
- An operating lease does not impact your financial statements. An owned asset appears on your balance sheet along with a corresponding liability. This situation may affect your financial ratios and your ability to obtain credit from a financial institution.
Source: Equipment Leasing Association.
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