External sources of finance come from outside the business. Leasing 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.
1. Leasing
Leasing is obtaining the right to use assets in exchange of paying a leasing charge, or rent, over a fixed period of time.
The business does not need to raise long-term capital to buy the asset. Through leasing, the business acquires, but not necessarily purchase, Fixed Assets over the medium term.
This is a form of hiring whereby a contract is agreed between a leasing company (the lessor) and the business (the lessee). The lessee pays rental income to hire assets from the lessor. The lessor is the legal owner of the assets. Whilst the ownership remains with the leasing company.
Periodic payments are made over the life of the agreement, but the business does not have to purchase the asset in the end.
When is leasing used?
Leasing is most often used as a source of finance for Non-Current Assets, in particular land, buildings, machines, office equipment, tools or vehicles. You can visit www.leasing.com to check how the car leasing works in practice.
Leasing is suitable for business customers who do not have the initial capital to buy such assets. This consequently releases cash for other purposes within the business.
Benefits of leasing
- Cheaper in the short-term. Leasing Fixed Assets allows the business to avoid spending large amount of money on cash purchase. Regular leasing payments will be spread out over several years. It can be cheaper to lease the asset paying monthly rent rather than to pay higher interest on the loan taken to buy that asset. Leasing is a very good source of finance for all kinds of start-up businesses given lower initial cost and lower capital requirements to access productive assets.
- Improves liquidity. While leasing is not a cheap option, it can improve the cash-flow position of a company in the short-term and medium-term. It is because monthly Cash Outflows on the Cash Flow Forecast to pay for the lease will be of lower amounts and very stable. If the business instead decides to purchase an expensive asset for cash, that extremely large one-time payment may cause liquidity crunch. So, leasing balances Cash Outflows.
- Avoids costly repairs and maintenance. The leasing company (the lessor) is responsible for the maintenance and repairs of the asset. For those businesses that operate in the sectors where technology becomes obsolete very fast, leasing can save the firm from the risk of spending huge amounts of money on technology. Technology becomes outdated fast. In the presence of rapidly changing technology, companies have to bear high risk of obsolescence if they purchase assets instead of leasing them.
- Assets of high quality can be afforded. The risk of using unreliable or outdated equipment can be significantly reduced. The business can lease very good machines and equipment for the small fraction of the purchase price. Also, the leasing company is obliged to update the asset as a part of the leasing agreement.
- Reduces TAX. Spending on leased assets are classified as business expenses, or Fixed Costs. Hence, they are TAX-deductible. Therefore, the TAX bill for the year of the lessee is reduced. Lease expenses get the same treatment on the Profit & Loss Account (P&L) as interest expenses on a bank loan. This will overall increase Net Profit After Interest and TAX.
- Better usage of capital. Instead of ‘freezing’ large amounts of money in Fixed Assets to purchase them for cash, the business may use that capital more productively. In fact, leasing releases precious capital . This can be used either fund Working Capital of a business, or pay for business growth. Or, the business can also save money waiting for better investment opportunities.
- Provides flexibility. The lessee can terminate the lease in case it does not require to use the asset any longer. Therefore, it is a very convenient way of financing expensive Fixed Assets. Also, leasing can provide much greater flexibility to businesses. When it may need to expand in the current location, or relocate somewhere else in the future.
Drawbacks of leasing
- No permanent ownership. The leased asset is never owned by the business, but the ownership remains with the leasing company. At the end of the lease agreement, the business must give the asset back to the leasing company. However, sometimes, the lessee holds the right to buy out the asset and terminate the leasing contract. This can provide additional flexibility to the business.
- More expensive in the long-term. Leasing is more expensive than the outright purchase of the asset or hire purchase. There are many financial benefits of owning the assets such as depreciation or appreciation in value which are lost when leasing. Because lease payments are treated as expenses in financial accounts, the assets will not belong to equity on the Balance Sheet. Also, the business cannot benefit from any appreciation in the value of the land and buildings over time. Additionally, monthly payments must be made no matter the asset is being used or not.
- No alterations in the asset possible. As the business is not the owner of the asset, it cannot roll out any changes or modifications in the leased equipment. The lessee is not free either to make any additions to the asset even though they might improve it or increase its value. On the contrary, in case of purchasing the asset, the buyer can alter the asset anyhow he wished to increase its utility.
- Initial paperwork. In order to start a lease agreement, thorough documentation must be prepared by the business. Entering into leasing assets is usually a complex process when it comes to time required to finalize the transaction. This puts start-up companies in a disadvantaged position as new business do not have any trading or credit history.
- Penalties for terminating the lease agreement. The business will be required to pay certain penalties, if the lease agreement is terminated before the expiry of the lease period.
In summary, leasing means obtaining the use of a Fixed Asset, or renting a Non-Current Asset. In return for having the right to use that asset, the business pays a fixed amount of money to the leasing company. This payment is over a fixed period of time, usually made monthly or quarterly.
