A lease is in essence an extended rental agreement under which the owner of the equipment allows the user to operate or otherwise make use of the equipment in exchange for periodic lease payments. In leasing terminology, the owner is the lessor, the user is the lessee. Equipment leasing is a popular option for companies of all sizes. The Equipment Leasing Association of America estimates that 80 percent of all companies lease at least some of their equipment, and the organization estimates that firms leased $220 billion worth of goods in 2004, projected to reach $229 billion in 2005. But equipment leasing is particularly favored by many small businesses, which often have fewer options because of limited capital.
The two primary types of leases are operating and long-term or "capital" leases. Operating leases are characterized by short-term, cancelable terms; the lessor bears the risk of obsolescence and enjoys such benefits as depreciation, including, if applicable, accelerated depreciation. These leases are generally preferable when the company needs the equipment for a short period of time. Under the usual terms of operating leases, a lessee can usually cancel the lease, assuming prior notice, without a major penalty. Long-term, "capital," non-cancelable leases, also known as full payout or financial leases, are sources of financing for assets the lessee company wants to acquire and use for longer periods of time. Most financial leases are "net" leases, meaning that the lessee is responsible for maintaining and insuring the asset and paying all property taxes, if applicable. Financial leases are often used by businesses for expensive capital equipment.
In addition to these two basic leasing models, a considerable variety of other lease arrangements are often used. These leases, each of which combine different financial and tax advantages, are actually hybrids of financial and operating leases that reflect the individual needs of lessor companies. For example, full-service leases are leases wherein the lessor is responsible for insurance and maintenance (these are commonplace with office equipment or vehicle leases). Net leases, on the other hand, are leases wherein the lessee is responsible for maintenance and insurance. Leveraged leases, meanwhile, are arrangements wherein the cost of the leased asset is financed by issuing debt and equity claims against the asset and future lease payments.
The Size of the Ticket
Leases are also classified as "small ticket," "medium," and "large ticket" leases based on the value of the equipment to be leased. The small ticket lease covers items up to $100,000 in value; large ticket leases cover item costing more than $2 million. The medium, of course, is the area in between. The small ticket lease is of special interest to the small business because getting approval for such leases rarely involves much more effort than qualifying for a credit card. As the values of equipment rented increase, obtaining the lease comes more and more to resemble a major loan application.
A Bumpy Playing Field
Small business owners need to keep in mind that lease rates can vary considerably from one lease company to another. Lease companies also may charge different rates for the same piece of equipment depending on various characteristics of the business that is seeking the lease. Factors that can impact the lease rate include the credit history of the lessee, the nature of equipment wanted by the lessee, the length of the lease term, and whether the lessee or lessor is the primary beneficiary of tax credits associated with the transaction.
Companies can finance their capital equipment by debt or equity. Capital leases are a form of debt-equity financing since such leases act like loans, must be recorded as liabilities on balance sheets, and are also treated as liabilities by the IRS. Operating leases, however, permit the company to obtain equipment with virtually no upfront capital outlay and with the lease payments treated as a deductible cost of business. For most small businesses, therefore, the principal motive for leasing is cash flow—the ability to get equipment now without a major expenditure of cash. Some companies able to purchase still prefer to lease because their tax situation is such that they cannot benefit from the depreciation. They may also wish to maintain a debt-equity ratio that will attract new investment more easily, and leasing rather than investment will accomplish that end. For some companies, engaged in a rapidly evolving technological market, using leased equipment under short-term leases permits them to exchange new and better equipment more rapidly than would ownership of a capital lease.
The elements of a lease agreement worth pondering in advance by the small business are on the following checklist. Each item should be viewed in light of the ultimate goal.
- Lease duration. If equipment needs are likely to change rapidly, a shorter lease period, even at a higher cost, may be desirable. When the equipment is standard, lowest price may be available for the longest duration.
- Payment due the lessor. This is one of several financial aspects the small business must consider in light of its projected cash flow.
- Financial terms (date of the month that payment is due, penalties for late payment, etc.)
- Residual values, purchase options. If the lease is just another way of purchasing equipment, the terminal point of the lease becomes important.
- Market value of equipment. The business needs to assess insurance costs (especially in capital leases).
- Tax responsibility. As outlined above, operating and capital leases have different tax implications.
- Updating or cancellation provisions—especially important when technological changes are swift.
- Lessee renewal options.
- Penalties for early cancellation without good cause.
- Miscellaneous options (security deposits, warranties).
FINDING A LEASING COMPANY
Business consultants and long-time equipment lessees agree that leasing companies vary considerably in terms of product quality, leasing terms, and customer service. Small business owners should approach a number of lease companies if possible to inquire about lease terms. They should then carefully study the terms of each outfit's lease agreements, and check into the reputation of each company (present and former customers and agencies like the Better Business Bureau can be helpful in this regard).
Finally, it is also important for entrepreneurs and business owners to take today's fast-changing technology into account when considering an equipment leasing arrangement. When dealing with computer systems or those heavily based on electronics, the owner is well advised to locate leasing companies that specifically service such needs and offer, up front, lease arrangements that facilitate rapid change.
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