Lease financing is a type of contract under which the legal owner of asset gives right to another person for using it, in exchange for periodical payments on regular basis called lease rental. The owner of asset is known as lessor and the one using assets by doing regular payments is known as lessee. Lease financing is one of the key sources available for both medium as well as long-term finance whereby person gets facility of using an asset without purchasing it. Under this agreement, the ownership of asset remain with owner (lessor) and another person is only given right to use it. At the end of lease agreement, an option is available to lessee to either renew the lease agreement or purchase the asset. Both parties sign the written document to enter into legal relationship and if anyone fails to uphold the contractual terms face consequences.
Lease are legal as well as binding contracts defining the terms of rental agreements in real estate, and real and personal property. The duties of each party are decided via these contracts for maintaining the agreement and are enforceable by each one of them. Although all leases are not of same type but carries same features like amount of rent, rent due date, expiration date of lease etc.
Features of Lease Financing
The main features of lease financing are as follows: –
- Contract: A contract is entered into by 2 parties under lease financing involving an owner and user. It is a legal agreement where both parties need to necessarily abide by their respective duties.
- Assets: The asset or property is the subject matter for which lease financing contract is made.
- Lease period: Lease period is the period of time during lease is non-cancellable normally. The asset cannot be return by lessee and cannot pay whole of lessor’s investment within this period.
- Term of lease: Term of lease refers to time period for which agreement of lease will remain in operation.
- Rental payments: Rental payments are regular payments made by lessee to lessor for getting the right of using an asset or property. It is amount paid for lease transaction and therefore also called lease rental.
- Maintenance: It is the provision related to payment of maintenance and repair cost, insurance, taxes, and various other expenses associated with asset which is leased.
- Termination: The lease contract gets terminated at end of period. The tenure for lease contract is decided by both the parties at time of making agreement.
- Renew or purchase option: Once the contract gets terminated, there are 2 options available which are renew or purchase option. It means either the expired contract should be renewed or lessee should buy the asset from lessor by making payment.
- Ownership: Ownership title is important point in lease financing contract which remains with the lessor. The contract only provides right of usage to lessee while the ownership is being kept with lessor.
- Default: On receiving the asset tittle in exchange, a lessee may be liable to all future payments at once.
Types of Lease Financing
Lease are of different types which are classified on the basis of nature and on the basis of method. On the basis of nature, lease is of 2 types: – Operating lease and financial lease. On the basis of method, lease is of 3 types: -Direct lease, leverage lease and, sale and leaseback.
All these lease types are well-explained in points given below: –
- Financial lease: Financial lease or capital lease is a longer time-period lease which is non-cancelable in nature. It obligates lessee for making regular payments for asset usage over a predetermined period of time. Under this lease type, all risk and rewards of ownership are transferred by lessor to lessee in exchange for lease rentals. In simple words, lessor put lessee in same condition in which he would have been if asset was purchased by him. There are 2 phases of financial lease which are primary period and secondary period. Primary period is non-cancellable period in which lessor covers his total investment amount via lease rentals. The secondary period is one which follows primary period and has smaller amount of lease rentals than that of primary period.
- Operating lease: Operating lease is lease which is not a financial lease and used for short-term lease. In this type of lease, risks and rewards associated with asset ownership are not transferred to lessee by lessor. The total amount of investment is not recovered here by lessor in primary period of lease. Operating lease is also known as service lease whereby lessor provide advice to lessee with regard to repair, technical knowhow and maintenance of leased asset. The term of operating lease is too less than the economic life of asset. Lessor enjoys right to terminate lease via giving a short notice and there is no provision for penalty charges in such cases.
- Direct lease: Direct lease is type of lease under right to use asset is acquired by firm directly from manufacturer. The asset ownership remains with manufacturer and right to usage of asset is provided to firm in exchange of lease rental.
- Leveraged lease: Leveraged lease is similar to direct lease type of lease financing. The only exception under this method, is involvement of third party (lender) in addition to lessee and lessor. The purchase cost of asset to be leased is partly financed by lender, the lessor turns out to be borrower.
- Sale and leaseback: Under sale and leaseback type, a firm first sell off the asset owned by it and then lease same asset back from buyer. In this way, lessee gets asset for usage and also gets cash at the same time.
Advantages of Lease Financing
Various advantages of lease financing are as discussed in points given below: –
- Saving of capital: Lease financing provide major benefit of saving capital of business organization via offering 100% finance. The entire cost of machinery to be used by firm is covered under leasing. User is not required to pay any margin money due to no down payment. This way leasing helps a lot in saving financial resources and utilizing them for other productive resources such as purchase of raw materials.
- Planning of cash flows: Right planning of cash flows is must for ensuring smooth functioning of business operations. The lessee is easily able to plan its cash flows adequately via leasing. Rental payments are made out of cash earned by business from usage of leased assets.
- Improvement in liquidity: Lease financing helps a lot lessee in enhancing its liquidity position. With the adoption of sale and leaseback technique, lessee gets cash as well as asset for usage at the same time.
- Flexibility and convenience: Lease financing is a flexible and convenient type of finance facility available for lessee. The agreements of lease are tailor-made with respect to lease rentals and lease period in accordance with needs of lessee.
- Shifting of Obsolescence risk: It saves the business from risk of obsolescence as lessee is not required to make huge investment for buying an asset. He/She can use the asset by leasing it and paying lease rentals on regular basis. In business sector, there are high chances of technology getting outdated with time, therefore this way it saves from huge risks and yield greater returns.
- Off-the-Balance-sheet financing: Leasing offers “off-the-balance-sheet’’ financing option for lessee as lease does not appear on company’s balance sheet. It is neither classified as an asset nor as liability.
- Tax benefits: Leasing financing also offers tax benefits to lessor. The payments or expense associated with leasing are treated as operating expenses and therefore are tax deductible.
Disadvantages of Lease Financing
The disadvantages of lease financing are as follows: –
- Lease expenses: Lease financing comes with high expenses for lessee. The lease payments are considered as expenses but not equity payments towards an asset. These payments include margin for lessor as cost of obsolescence risk is also included in it, which thereby raise the overall cost of financing.
- No ownership: Leasing does not impart ownership of asset to lessee. After the end of leasing period, no ownership comes to lessee although he/she has paid a good sum of payments toward asset over the years.
- Processing and documentation: There are lot of documentation and numerous processing need to be completed in leasing. Overall, entering into lease agreement is a complex procedure requiring proper examination of documents and also asset to be leased.
- Limited access to other loans: Lease financing may obstruct the access of business to other forms of debt if in case investors consider the long-term lease as debt for business. Firms may not be freely able to tap capital markets or avail other finance facilities in case funds need arises.
- Reduced return for equity holders: Leasing financing have negative impact on income of equity holders due to large lease rental payments by business. The overall net income of firm gets reduced due to lease expenses without any appreciation in value which bring down the return for equity shareholders.
- Limited financial benefits: Leasing offers limited financial benefits to business. For a business who is doing lease payments towards land cannot benefit form any appreciation in land value. Agreement of long-term lease remains a burden for business which is locked and carries fixed expenses for several years. In cases where asset is no more useful or does not meet requirements of business, the lease rentals become a burden.
- Debt: The long-term lease is treated as debt by investors although it does not appear on company’s balance sheet. The valuation of business is adjusted by investors in order to include leases as an debt for business.