External sources of finance come from outside the business. Sale-and-leaseback belongs to external sources of finance. When businesses need to use the money for a few years (between one and five years), this creates the need for medium-term finance.
2. Sale-and-leaseback
Sale-and-leaseback is a transaction when the business sells a particular Fixed Asset to raise finance, and immediately lease that asset back. In particular, this will include selling land, buildings, machines, office equipment, tools or vehicles owned by the business, and then renting them from the new owner.
Businesses will sell some of the Fixed Assets that they still intend to use, but which they do not need to own. In reality, the business transfers the ownership on paper although the physical asset does not even leave the business’s premises.
Through sale-and-leaseback, the firm is able to raise a substantial amount of capital. However, there will be additional Expenses, or Fixed Costs, as the business will now be leasing the asset, hence need to pay rental payments.
Benefits of sale-and-leaseback of Fixed Assets
- Large amount of money can be raised. The amount of capital raised by selling property can be quite substantial. It can often raise very large amounts of money quickly without any direct cost to the business. The sale-and-leaseback agreement allows the business to get cash influx that can be used for future expansion, either internally or externally. The cash gained can also be used for providing extra Working Capital.
- Helps with debt reduction. The proceeds from selling assets can be used to reduce or eliminate business debt. Hence, it will allow the business to lower interest payments and increase profitability. In extreme cases, sale of Fixed Assets can help defend against potentially disruptive events such as bankruptcies. Overall, the company can improve the health of its Balance Sheet.
- Improves liquidity. Sale-and-leaseback arrangements enable firms to improve liquidity position by realizing cash from the sale of Fixed Assets and retaining the economic use of the same. The company is now free to use the cash that was previously tied up in the property to continue operations.
- Avoids costly repairs and maintenance. The new owner is now responsible for the maintenance and repairs of the asset.
- Making a profit. Certain types of assets such as land and buildings appreciate a lot in value over a long period of time. For the business this means that, if the value of assets at the time of sale exceeds the total initial investment, the business will earn the return from selling that asset.
Drawbacks of sale-and-leaseback of Fixed Assets
- No permanent ownership anymore. The leased asset is never owned again by the business. The ownership will fully remain with the new owner, or a leasing company. At the end of the leaseback agreement, the business must give the asset back.
- Difficult to find a suitable buyer. The business may not find anyone for a sale-and-leaseback transaction. There must be a person or a company who wishes to own the asset and then agree to rent it out to the business. However, these days on the market, there are many specialist companies involved in sale-and-leaseback transactions
- Additional leasing expenses. Regular contractual leasing charges must be paid every month or every quarter to the new owner. This will increase future Fixed Costs of the business, therefore impact Net Profit. The amount of rent is likely to increase every time when the lease is renewed.
- Various TAXes must be paid. When selling land or buildings, the business as the seller will need to pay various TAXes and other transaction fees in order to transfer the ownership of the asset. This may be both costly and time consuming.
In short, sale-and-leaseback occurs when the business sells a Fixed Asset, and then commits to lease that same asset back from the new owner for a fee. Under this transaction, an asset is sold to someone else and then is immediately leased back to the first owner.
