What is lease financing? Give its …

Lease financing is one of the important sources of medium- and long-term financing where the owner of an asset gives another person, the right to use that asset against periodical payments. The owner of the asset is known as lessor and the user is called lessee.

The periodical payment made by the lessee to the lessor is known as lease rental. Under lease financing, lessee is given the right to use the asset but the ownership lies with the lessor and at the end of the lease contract, the asset is returned to the lessor or an option is given to the lessee either to purchase the asset or to renew the lease agreement.

PURPOSE OF LEASING?

The purpose of choosing a lease can be many. Generally, a lease is structured for following reasons.

• Benefits of Taxes: Tax benefit is availed to both the parties, i.e. Lessor and Lessee. Lessor, being the owner of the asset, can claim depreciation as an expense in his books and therefore get the tax benefit. On the other hand, the lessee can claim the MLPs i.e. lease rentals as an expense and achieve tax benefit in a similar way.
• Avoid Ownership and thereby Avoiding Risks of Ownership: Ownership is avoided to avoid the investment of money into the asset. It indirectly keeps the leverage low and hence opportunities of borrowing money remain open for the business. A Lease is an off-balance sheet item.

ADVANTAGES OF LEASING

• BALANCED CASH OUTFLOW-The biggest advantage of leasing is that cash outflow or payments related to leasing are spread out over several years, hence saving the burden of one-time significant cash payment. This helps a business to maintain a steady cash-flow profile.

• QUALITY ASSETS-While leasing an asset, the ownership of the asset still lies with the lessor whereas the lessee just pays the rental expense. Given this agreement, it becomes plausible for a business to invest in good quality assets which might look unaffordable or expensive otherwise.

• BETTER USAGE OF CAPITAL-Given that a company chooses to lease over investing in an asset by purchasing, it releases capital for the business to fund its other capital needs or to save money for a better capital investment decision.

• TAX BENEFIT-Leasing expense or lease payments are considered as operating expenses, and hence, of interest, are tax deductible.

• OFF-BALANCE SHEET DEBT-Although lease expenses get the same treatment as that of interest expense, the lease itself is treated differently from debt. Leasing is classified as an off-balance sheet debt and doesn’t appear on company’s balance sheet.

• BETTER PLANNING-Lease expenses usually remain constant for over the asset’s life or lease tenor, or grow in line with inflation. This helps in planning expense or cash outflow when undertaking a budgeting exercise.

• LOW CAPITAL EXPENDITURE-Leasing is an ideal option for a newly set-up business given that it means lower initial cost and lower CapEx requirements.

• NO RISK OF OBSOLESCENCE-For businesses operating in the sector, where there is a high risk of technology becoming obsolete, leasing yields great returns and saves the business from the risk of investing in a technology that might soon become out-dated. For example, it is ideal for the technology business.

• TERMINATION RIGHTS-At the end of the leasing period, the lessee holds the right to buy the property and terminate the leasing contract, this providing flexibility to business.

DISADVANTAGES OF LEASING

• LEASE EXPENSES-Lease payments are treated as expenses rather than as equity payments towards an asset.

• LIMITED FINANCIAL BENEFITS-If paying lease payments towards a land, the business cannot benefit from any appreciation in the value of the land. The long-term lease agreement also remains a burden on the business as the agreement is locked and the expenses for several years are fixed. In a case when the use of asset does not serve the requirement after some years, lease payments become a burden.

• REDUCED RETURN FOR EQUITY HOLDERS-Given that lease expenses reduce the net income without any appreciation in value, it means limited returns or reduced returns for an equity shareholder. In such case, the objective of wealth maximization for shareholders is not achieved.

• DEBT-Although lease doesn’t appear on the balance sheet of a company, investors still consider long-term lease as debt and adjust their valuation of a business to include leases.

• LIMITED ACCESS OF OTHER LOANS-Given that investors treat long-term leases as debt, it might become difficult for a business to tap capital markets and raise further loans or other forms of debt from the market.

• PROCESSING AND DOCUMENTATION-Overall, to enter into a lease agreement is a complex process and requires thorough documentation and proper examination of an asset being leased.

• NO OWNERSHIP-At the end of the leasing period, the lessee doesn’t end up becoming the owner of the asset though quite a good sum of payment is being done over the years towards the asset.

• MAINTENANCE OF THE ASSET-The lessee remains responsible for the maintenance and proper operation of the asset being leased.

• LIMITED TAX BENEFIT-For a new start-up, the tax expense is likely to be minimal. In these circumstances, there is no added tax advantage that can be derived from leasing expenses.