In lease financing, the owner of a particular asset enters into a contract with the customer who wishes to rent the asset for a specific period of time. Capital leases and sales leases are contracts where a company grants an asset to a person in return for a recurring payment. Finance terms refer to the payment of rental as lease rental, the owner of the asset as a lessor, and the user as a lessee.
Lease financing examples
The following examples of financial leases can be found in a wide range of industry sectors and require a large lump sum:
- Diesel engines
- Heavy machinery
- Plant equipment
Lease Financing Types
Lease financing can be categorized into three categories: the transfer of risk, the lease period, and the number of parties involved.
- Finance lease
- Operating lease
- Sale and Leaseback
- Leveraged Leasing
- Finance Lease
For lease rentals, the lessor transfers all substantial risks and rewards of ownership of assets to the lessee. A long-term lease can’t be canceled before it expires; it is a common type of lease. There are two phases in the finance lease: the primary and secondary periods.
During the primary period, the lessor is able to recover his investment through lease rentals, which lasts for an indefinite time period. During the secondary period, also known as peppercorn rental, you pay a smaller lease rental amount than during the primary period.
Finance Lease Features
- Ownership of the property passes to the lessee when the lease term ends, as per the main lease agreement or a separate contract.
- During the primary period of the lease, lessors charge a lease rental that covers their investment.
- The lessee must take responsibility for the asset’s maintenance and management.
- No asset-based risks or rewards are taken by the lessor.
Lease of Operation
A lease is a contract in which the lessor allows the lessee to use a particular asset for a specified period, without any transfer of ownership rights. Opting for an operating lease instead of a finance lease has the advantage of being short-term and cancellable.
Operating lease features
- There is a considerable difference between the lease term and the economic life of the asset.
- If the lease is terminated by the lessee within a short notice period, no penalty will be charged.
- Ownership of an asset involves risks and rewards for the lessor.
Leasebacks and sales
Financial leases involve the sale of an asset to another party who leases it back to the seller for a specific rental amount over a specific period of time. Most sellers and lessees of real estate make the sale and lease back arrangement when they face short-term liquidity crises.
Leasing on leverage
Recent years have seen leveraged leasing become a popular form of leasing that involves three parties, namely the lessee, the lessor, and the lender. As part of this process, the lessor provides an equity portion of the cost of the asset under lease, and the third-party lender provides the financing balance. Oil rigs, aircraft, and railway equipment are commonly financed this way.
Lease financing has several advantages
The rate of return on leasing is much higher than the interest payable on financing the asset, ensuring a balanced cash flow and a highly profitable business. Businesses reduce the burden of one-time significant cash payments and maintain a steady cash flow profile.
Assets of high quality
The lessee will still remain the owner of the assets that are leased by the lessor to the lessee. A business that wishes to invest its finances in quality assets benefits from this agreement.
As soon as the lessor and lessee sign the agreement, the lessor receives an assured and regular income within the specified timeframe.
Benefits of taxation
Rent or lease payments are considered operating expenses, so they are tax deductible, and they are included in the lessor’s profit.
Planning is key
In financial leasing, businesses can plan expenses actively by keeping the lease expenses constant or increasing in line with inflation over the asset’s life.
Friendly to inflation
Even in cases when the asset’s cost rises, lease financing requires the lessee to pay a fixed amount of rental fees each year. Leases are therefore inflation-friendly.
Capital expenditure is low
It is considered to be a great option for start-up companies and new businesses since it allows them to build revenue with lower capital expenditures and initial costs.
The end of obsolescence is impossible
As a result of high-risk technology, brands today are more likely to become obsolete. Investing in lease rentals, on the other hand, can yield high returns and help businesses thrive.