Lease Financing | Finance Lease vs Operating Lease

Lease Financing

Lease financing is a modern terminology in the field of financing that is being applied by businesses throughout the world. Basically, there are two parties involved in lease financing

1. Lessor : A lessor is named for the leasing company that buys a specific asset and hands over it to the lessee to use.
2. Lessee (Borrower): The lessee is the one who borrows a specific asset from a lessor in order to use it for his interest.

Lease As Agreement

Lease is actually an agreement or contract, just like loan agreement. Actually in which the lessee has to pay certain regular installments throughout the entire life of the lease agreement. If he fails to pay the regular payments, then he would be forced towards bankruptcy. In fact in which the lessor captures the leased asset to recover his amount. If the claiming amount is much higher, then the lessee can be bound to pay the installments for one year.

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Almost 10 to 30% of fixed assets are acquired through leasing in most of the countries of the world. Such as machinery, furniture, warehouse, airplane, cars etc.

Control Vs Ownership

The ownership of the leased asset is held by the lessor (leasing company). Whereas the control of the asset is handled by the lessee.

Businesses Favorable for Lease Financing 

Following are some of the businesses that are favorable for lease financing.

1. The businesses that require heavy investment in fixed assets and are cyclical in nature. For example, the airplane company is quite suitable for the lease financing for the purchase of heavily expensive airplanes.
2. Hi-tech businesses are more suitable, because the technology quickly obsoletes. For example, software houses must acquire lease financing as there are emerging new software that are replacing the older ones at a rapid rate.
3. Specific businesses that have uncertain demand for the relative product or service which makes the lifespan of asset un-forecasting.
4. In some cases the maintenance cost and operational risk is shared by the lender. For example the computer and hardware related business is facilitated with the repair and maintenance service by the IBM Company.

Types Of Lease Financing

There are three main types of lease financing which are as follows.

Financial Lease (Capital Lease)

These types of lease financing are also known as Capital Lease. Following are the main characteristics of Financial Lease.

• The Most famous kind of leasing, especially in Asian region of the world.
• The lease agreement is fully amortized in Financial Lease, which means that the lessor gets the principal amount of the asset as well as the profit of his investment in such asset. Both of these amounts are included into the rental payments of lease throughout the entire life of the agreement.
• The lessee does not cancel the lease before maturity of agreement. If he tries to cancel it before maturity, then he will have to pay a heavy charge because the landlord has invested an adequate amount in the asset. The lessor had made his calculations in shape of Net Present Value of this investment and he bears loss if the lease agreement is ended before maturity.
• At the maturity of the lease agreement, the ownership of the asset is transferred to the lessee as he has paid all the lease installments.

Example

Suppose a student wants to buy a laptop for his study purposes and he does not have enough money to buy it. He may go to the market and select a suitable laptop for himself. He negotiated with the shopkeeper and finally agreed at the price of $ 25,00. Then he may contact a leasing company and offer the company to buy the laptop for him at the suggested price. So, the leasing company purchases the laptop and gives it to the student to use. In return, the leasing company charges $ 250 as monthly lease rentals for one period of ten months. After one year, the company transfers the ownership of the laptop to the student as he has already paid all the monthly lease rentals.

Advantages of Financial Lease (Lessee Point of View)

Following are some of the advantages that a lessee can avail through a Financial lease.

• A company that needs to purchase a new plant on an urgent basis, but it does not have sufficient money to buy it, then Financial Lease is the best option.
• In some cases the lease assets (including lease liabilities) are not included in the balance sheet. This means that the debt ratio and capital structure of the relative company is not affected by leasing as in the case of loan. So, some countries restrict this thing in their rules of accounting standards.
• The company which does not justify its increase of assets in its balance sheet can gradually eliminate the capital expenditure in the leased assets.
• The lease rentals are tax-deductible amounts, just like the interest payments on a loan.

Operating Lease (Service Lease)

It is also known as Service Lease. Below are the main features of Operating lease.

• It is also much similar to financial lease, but here the lessor has to provide the maintenance services to the lessee regarding the leased asset.
• In most cases the vendor/supplier himself is the lessor.
• The main difference of Operational Lease with Financial Lease is that the lease agreement is not fully amortized. This means that the lessor may not recover the principal amount as well as the profit on his investment.
• As the Operating Lease is not fully amortized therefore the lessee has the option to cancel the agreement of lease at any time. So, the ownership of the asset remains to the lessor.

Example

Suppose a leasing company offers a good condition car on rent for $ 200 per day. If a person makes an agreement for five days to use the car. Then the leasing company does not recover the full amount of car from that person in five days. The person uses the car and he cancels the agreement after three days. Then still he pays a three days amount which is equal to $ 600 and the maintenance cost of the car is handled by the leasing company.

Sales and Lease Back

Following are the main features of this amazing kind of leasing.

• Sales and Lease back is the innovative category of financial lease in which a person sells his asset to a leasing company at a certain price. He receives the money and then he makes a leasing agreement with the company to lease of the same asset. In this way he creatively uses the cash of the sold asset to pay the lease rentals and finally buyback assets upon maturity date.
• The leasing company proposed the lease rental payments in such a way that the total sum is higher than the original price of asset. In this way the leasing company also gets some profit on its investment.

Example

Suppose a person wants to start a book shop as his business and he does not have enough money. But he possesses a van and he approaches a leasing company to sell his van. He finally sold his van for $ 20000 and leased the same van for one year period at a rental payment of $ 2000 per month. Then he starts the book shop and generates $ 3000 per month as revenue. So he pays the rental amount for one year and receives the ownership of his van. In this way he efficiently utilized his van to get debt. On the other hand the leasing company also earns profit of $ 4000 besides the actual price of the van.