There are a variety of finance options for businesses looking to purchase expensive assets that will help them to grow. Two of the most popular asset finance options are operating and financing leases.
In this guide, we explain what both options are, how they can help your business and which one might be most suitable for your situation.
In this post we'll cover:
Which is more flexible?
What is a Financing Lease?
Financing leases, sometimes referred to as capital leases, usually require a full payout agreement. Meaning, the total of the rentals includes the full cost of the equipment and the interest that has been accrued over the given period.
With a finance lease, you can spread payments over the term of your lease to help you manage cash flow while getting the equipment or staff needed for your business.
While the leasing agreement is underway, the leasing company is the owner of the equipment until the leasing period ends.
Example of a financing lease
A construction company builds multiple plots around the UK continuously, all of which require an excavator. Without being able to excavate the areas they will be unable to build solid foundations which halts all of their projects. Completely stopping revenue like this could destroy the business.
The construction company owner needs to ensure that they have a good quality excavator that can work for years to come in order for them to expand. But excavators can be £250,000+ so spreading this cost over months will drastically reduce the cash flow strain helping them to stay profitable. They will also be able to own the excavator at the end of the lease.
Financing Lease: A quick definition
A financing lease is when a company gives a company control over an asset or piece of equipment for an agreed period of time.
What is an Operating Lease?
An operating lease involves periodic payments for the use of any equipment that the lessor owns. In most cases, these contracts are short term and it is the responsibility of whoever took the lease to ensure the upkeep of the equipment during the period of payments.
One key difference for operating leases is that there are no purchasing options so the lessee will never be able to own the equipment.
Example of an operating lease
An IT Support business needs servers to house their clients and their own websites so they can backup, access and fix their websites whenever they need to. A reliable web server is essential to their business and allows them to generate income.
The business owner has to ensure they have a reliable and adequate server for this reason, but due to their expanding client base, they need a better server than previously estimated. A high quality server can cost upwards of £20,000 so in this scenario the owner might lease one. This would allow them to get the asset immediately while spreading the costs and giving the option to upgrade the server if the business needs it.
Operating Lease: A quick definition
Essentially, operating leases are assets rented by a business. Ownership of these assets is not transferred to the lessee when the rental is over.
The main differences
Financial Lease | Operating Lease |
|---|---|
Lease provider is responsible for the maintenance of the leased equipment | The lessor is responsible for the running cost and maintenance of the equipment they lease. |
Option to purchase the equipment | Need to return the equipment once the period is over |
Typically over a longer period (2-5 years) | Typically over a shorter period (12-36 months) |
Equipment included as an asset | Equipment classed an expense |
Which is more flexible?
The answer to this depends on what your goals are at the end of the lease.
Financing leases can provide a more flexible option as the lessee has the option to purchase the asset when the lease term comes to an end.
Whereas with operating leases, the lessee never owns the asset, but they do have the flexibility to upgrade equipment, and they don’t take on the burden of depreciation. There’s also no ownership risk with payments considered as operating expenses, making them tax-deductible (see more below).
Tax Considerations for Financing vs Operating Leases
Another difference between these two types of leases is how they are classified tax wise. Operating leases are considered rental expenses and are therefore deductible for corporation tax purposes.
In contrast with financing leases the lessee is able to claim capital allowance on the assets which can help to reduce tax liabilities.
When to Choose a Financing Lease
Financing leases are best suited for businesses that need to invest in equipment immediately and want to buy it but don’t have the capital available. It’s a way to help businesses purchase expensive equipment and spread the costs over a longer period of time. It also allows the lessee to become the owner once the lease period is over.
When to Choose an Operating Lease
Operating leases are perfect for businesses that don’t have the time or resources to deal with maintenance or the administration that comes with owning certain equipment. Another benefit would be that the assets aren’t showcased on the company's accounting record. They are particularly good if you need expensive equipment or assets that need to be replaced frequently.
FAQs
What classifies as a finance lease?
A finance lease is a lease agreement where the lessee effectively takes on most of the risks and rewards of ownership of an asset, even though the legal ownership remains with the lessor. It is classified as a finance lease if any of the following apply:
The lease term covers most of the asset's useful life.
The lessee has the option to purchase the asset at a price significantly lower than its fair value (a bargain purchase option).
The present value of lease payments is close to the asset's fair value.
The asset is tailored for the lessee and has limited use to others after the lease.
Essentially, a finance lease is more like purchasing the asset with instalments.
How do you determine if a lease is finance or operating?
A lease is a finance lease if you take on most of the risks and rewards of owning the asset, such as having the option to own it at the end. An operating lease is more like renting, where you don’t assume ownership or long-term responsibility for the asset.
Choosing the Right Lease for Your Business
If you are a small or medium sized business operating leases allow you to rent expensive assets that you might not otherwise be able to afford but are important to your operations. This helps you to keep costs low so you can buy the equipment outright in the future.
Whereas financing leases help businesses acquire assets while spreading the costs over time allowing them to keep initial investment low so they can grow. At the end of the period, they can also own the asset outright.
An asset finance broker can help you to find the best financial solution for your business.