Arranging finance for leasing and lease acquisition

Types of Leasing or Asset Financing for small business.

Paying cash for an asset can be a significant drain on working capital. Leasing the asset, however, gives access to the asset without paying for it all at once. All forms of leasing are basically rental agreements giving the lessee the right to use an asset owned by the lessor (finance company) for a specific period of time in return for regular payments (rental payments). You can lease almost anything, from equipment valued at a few thousand pounds to assets worth millions. Leasing contracts are flexible and can be tailored to your clients' needs.

When leasing, consider its effects on accounting, reporting, tax, and cash flow. This section will give you a general overview. It does not replace professional advice. You may wish to consult your accounting and tax advisors before finalising a lease transaction to garner the maximum benefit and avoid complications.

We can generally distinguish three major types of leasing: finance leasing, operating leasing and contract hire. Although strictly speaking not a type of leasing, we also include hire purchase in the following discussion

Types of asset financing.
Finance Leasing (Full Payout Lease). A tax driven finance facility where the lessor claims the writing down allowances. The risks and rewards of ownership rest with the lessee, so that the assets appear on their balance sheet. The lease has 2 periods, a fixed primary period during which the capital and interest are repaid, and an optional secondary period with minor annual rentals. There can be a “balloon” or lump sum payment equal to the anticipated value of the asset if appropriate. VAT is charged on the rentals and is reclaimable.

The lessee effectively acquires all financial benefits and risks without actually acquiring legal title. The leasing rate is computed to collect the full value of the asset (plus finance charges) during the contract period. At the end of the lease, the asset is sold to a third party and the lessee can receive a share of the sale proceeds (if the lease is not being extended). Generally, the lessee will not be able to become the owner of the asset at any time - unless a private arrangement is made with the third party. However, there is usually the option to extend the lease and as the lessee will have paid for almost the full value during the initial lease period, the rental payments for subsequent periods will be minimal (sometimes referred to as "peppercorn rental").

Finance Leasing can be considered as similar to Hire Purchase, except that at the end of the repayment period, the user doesn't actually own the equipment. However, they can either:

Return the equipment
Continue to use the equipment in exchange for a small annual payment
Sell the equipment to a third party at an agreed price

The finance lease or 'full payout lease' is closest to the hire purchase alternative. The leasing company recovers the full cost of the equipment, plus charges, over the period of the lease. Although the business does not own the equipment, they have most of the 'risks and rewards' associated with ownership. They are responsible for maintaining and insuring the asset and must show the leased asset on their balance sheet as a capital item.

When the lease period ends, the leasing company will usually agree to a secondary lease period at significantly reduced payments. Alternatively, if the business wishes to stop using the equipment, it may be sold second hand to an unrelated third party. The business arranges the sale on behalf of the leasing company and obtains the majority of the sale proceeds. Although a finance lease will look and feel the same as a hire purchase, one will not end up owning the asset at the end of the contract. Ownership remains with the finance company at all times. The agreement is structured so that the lessee pays off the whole value of the asset. If leasing a car worth £10,000, the lessee will pay the whole £10,000 plus interest during the lease. If they are still using the asset at the end of the original contract, a second agreement can be entered. This secondary agreement will be for a nominal fee. The lessee will be able to offset rental charges against profits and be able to claim VAT as well. The agreements can be structured in different ways but the broker may find that the lessee can choose when to sell the asset and, if so, get a rebate for the remaining rental charges.

Operating Lease: A "Rental" facility where the lessor claims the tax allowances and takes a real risk in the residual value of the assets being financed. Under the terms of accounting standard SSAP21 the lessor derives their profit from the disposal of the goods, with the customer having a "rental" to offset against Profit & Loss Account. The assets are never shown on the customer's balance sheet. VAT is charged on the rentals and is reclaimable.

Often with a shorter time frame than financial leasing (always significantly shorter than the working life of the asset), operating leasing is more like a regular rental. The lessor expects to be able to either sell the asset in the second-hand market or to lease it again and will therefore not need to recover the total asset value through lease payments. There may be an option to extend the leasing period at the end (this negotiation can only take place at the end of the initial rental period). As with finance leases, the user will not be able to become owner of the asset at any time but, contrary to financial leases, they will not share in the sale proceeds. If a business needs a piece of equipment for a shorter time, then operating leasing may be the answer. The leasing company will lease the equipment, expecting to sell it second hand at the end of the lease, or to lease it again to someone else. It will, therefore, not need to recover the full cost of the equipment through the lease rentals. This type of leasing is common for equipment where there is a well-established second hand market, such as cars and construction equipment. The lease period in this case will usually be for two to three years, although it may be much longer, but is always less than the working life of the machine. The business would not enter an operating leased asset on its balance sheet as a capital item.

Contract Hire: A form of operating lease (often used with cars and other vehicles) that includes a number of additional services such as maintenance, management or replacement if asset is in repair. Contract hire is a form of operating lease and it is often used for vehicles. The leasing company undertakes some responsibility for the management and maintenance of the vehicles. Services can include regular maintenance and repair costs, replacement of tyres and batteries, providing replacement vehicles, roadside assistance and recovery services and payment of the vehicle licences. This offers the user an opportunity to have the use of a piece of equipment, often tied in with a maintenance contract, for the duration of the agreement. Ownership remains with the finance company and the customer will pay a set fee over a period to use that equipment. The contract will outline a residual value at which the finance company will take back the equipment at the end of the contract.

A client could find this cheaper than a finance lease. If, for example, they wanted to buy a lathe for £10,000, a finance lease would be structured to pay off the whole amount plus interest over a period of, say, five years. However, under contract hire, the contract will specify a residual value that the goods will be worth at the end of the lease. Using our example of a £10,000 machine, the contract may specify a residual value of £2,000 at the end of a five year lease. The user will pay a total of £8,000 plus interest for the use of the asset during that time. For this reason, maintenance can be tied in to the contract to ensure that the asset will have the required residual value. One of the big benefits of contract hire to a small business is that there is no large capital outlay for equipment that could damage the company's balance sheet. While a business needs certain equipment, through a contract hire agreement only the rental charges will be shown on the balance sheet which should make it more attractive.

Lease Purchase: As hire purchase, except for the repayment profiles which are usually a number of monthly or quarterly rentals in advance. e.g. 3+33 on a 36 month agreement. Additionally there can be a deposit at the front end together with a monthly rental, and at the back end there can be a "Balloon" or lump sum payment approximately equal to the expected resale value (if appropriate). The customer retains the sales proceeds

Hire Purchase: An ownership facility, providing the customer with tax title to the goods and therefore the appropriate writing down allowances & sales proceeds - whilst deferring the cost over a period of time, usually 1-5 years. Additionally the customer is able to offset interest & reclaim all the VAT. Repayment profiles are usually a deposit, being a percentage of the cash price e.g. 5-20% + the VAT, followed by equal monthly repayments. Interest can be fixed or variable. The customer retains the sale proceeds at the end of the lease period or at the end of the asset’s working life. This is an agreement for the hiring of an asset with an option to purchase.

The legal title will pass to the lessee when all payments have been made. The term of a hire purchase must be significantly shorter than the working life of the asset. The lessee is are able to claim capital allowances as if they had purchased the asset outright, gaining immediate use of it. Hire Purchase agreements are typically written for domestic users, not so much for business users. Hire Purchase is a variation of lease purchase; most people will have come across this at some point in the High Street. Whether one is considering buying a car or a television, hire purchase is widely available. It allows the user to pay off the full amount over a defined period. At the end of that period, provided they stick to the terms of the agreement, they will own the asset. There is a capital allowance – currently 25% on the reducing balance – available under a hire purchase agreement. If a business is registered for VAT, it can also claim back the VAT on the asset upfront. Also, any interest that it pays can be offset against profits. At the end of the agreement, they will own the asset.

However, despite this hire purchase is far less common in business transactions now than ten years ago. Generally, if the user sees it as an asset that will keep its value, hire purchase is the option. However it does depend on what the user or client wants to do with the asset. Most businesses want to use but not necessarily own the equipment. In fact, small businesses are increasingly relying on full-service leasing contracts that allow them to use the asset without any of the hassles of ownership. The trend has spread from cars and vehicles, but is growing in other areas, such as IT. Small companies, in particular, do not have time to keep up to date with all the latest technology and what products are on offer. Instead, they can bundle the service in with the lease and ensure that somebody else keeps up to date for them. There is another reason that small businesses may have turned away from hire purchase. A startup business that has yet to turn in any significant profits may not be able to make best use of capital allowances. Instead, the bank or finance company can take advantage of those allowances and pass on the benefit through lower rentals.

End of Lease Options
At the end of the lease term, there are various options. Lease contracts can stipulate that the lessor

return the asset;
have the right to act as an agent to sell the asset to an independent third party; and/or
can renew the contract or enter into secondary periods.

It is important for the customer to anticipate future needs as each option has its advantages and disadvantages and will affect their monthly payments.

Choosing the Right Type of Finance
All types of financing offer different advantages and it is important that you assess your clients' circumstances and needs before committing them to a specific finance contract.
For example:

if they want to own the asset straight away, an outright purchase (cash or loan/overdraft) might be appropriate;
if they may want to own the asset at some point in time and want to take advantage of instalment payments, hire purchase might be the best option;
if they do not want to own the asset at all but require it for most of its useful life, consider a financial lease; and
if they require the asset for a period of time significantly shorter than the useful life of it, consider an operating lease.

Advantages of leasing

Better Cash Flow. Leasing gives access to the asset with minimal up-front payments and spreads the cost over time. The user pays for the asset with the income it generates while minimising the drain on working capital
No debt. An operating lease preserves credit options and does not influence credit limits as it is generally not classified as debt but as expense (note that this advantage does not apply to finance leases!)
Maximise Financial Leverage. A lease can often finance everything related to the purchase and installation of the asset and may free up cash flow to pay for items such as training
Simplified cash flow management. Lease payments are usually flat, making cash management more predictable and easier than with a variable rate loan. The fixed interest rate of a lease also helps if interest rates rise
Tax advantage. Operating lease payments are generally tax deductible just like depreciation charges but are made with pre-tax money. Cash purchases, in contrast, are made with after-tax money. Hire purchase agreements allow the lessee to claim capital allowances
Flexible time frames. Leasing contracts can be structured to fit your client's requirements. Use an asset as long as they need it without owning it forever
Hedge against obsolescence. Depending on the end-of-lease option, the lessee can just return the asset to the lessor. They will not have the hassle of selling the used asset or run the risks related to residual value and (technical) obsolescence
Additional advantages. Some leases offer additional advantages such as cancellation options or asset maintenance.

Disadvantages of leasing.

More expensive. A finance lease is usually more expensive than an outright cash purchase as the payments include finance charges. However, leasing may cost less than other forms of financing. Also consider the tax advantages when making this calculation
Additional Guarantees. Depending on the credit rating of your company, the lessor might require additional guarantees. These may be provided by the lessee, business partners or the bank and could affect personal credit rating or business standing with the bank
Fixed Term. It may be impossible, or at least costly, to terminate a leasing contract early
Fixed Interest Rates. Interest rates are usually fixed throughout the lease which may prove a disadvantage in times of falling interest rates.

Things to watch out for:

Return of Asset Conditions. If the user chooses to return the asset at the end of the lease, the condition in which and the place where it must be returned are important aspects to consider carefully
Notice Period. If a lease includes the option to renew take note of any time periods in which to give notice in case the lessee does not want to renew the contract. Some leasing companies will automatically renew the contract if the lessee fails to give notice
Purchase Rights. If negotiating the right to purchase the asset at the end of a lease, a predetermined fixed price offers more value as the 'fair market value', which theoretically is always available to your client
Maintenance Responsibility. Clarify which service and maintenance programs are included in the lease. If your clients are responsible for service and maintenance, make sure they do not have to provide an unreasonably high degree of it.

HOME ABOUT US ENQUIRY TERMS & CONDITIONS CONTACT US LINKS SITEMAP




	Types of Leasing or Asset Financing for small business. Paying cash for an asset can be a significant drain on working capital. Leasing the asset, however, gives access to the asset without paying for it all at once. All forms of leasing are basically rental agreements giving the lessee the right to use an asset owned by the lessor (finance company) for a specific period of time in return for regular payments (rental payments). You can lease almost anything, from equipment valued at a few thousand pounds to assets worth millions. Leasing contracts are flexible and can be tailored to your clients' needs. When leasing, consider its effects on accounting, reporting, tax, and cash flow. This section will give you a general overview. It does not replace professional advice. You may wish to consult your accounting and tax advisors before finalising a lease transaction to garner the maximum benefit and avoid complications. We can generally distinguish three major types of leasing: finance leasing, operating leasing and contract hire. Although strictly speaking not a type of leasing, we also include hire purchase in the following discussion Types of asset financing. Finance Leasing (Full Payout Lease). A tax driven finance facility where the lessor claims the writing down allowances. The risks and rewards of ownership rest with the lessee, so that the assets appear on their balance sheet. The lease has 2 periods, a fixed primary period during which the capital and interest are repaid, and an optional secondary period with minor annual rentals. There can be a “balloon” or lump sum payment equal to the anticipated value of the asset if appropriate. VAT is charged on the rentals and is reclaimable. The lessee effectively acquires all financial benefits and risks without actually acquiring legal title. The leasing rate is computed to collect the full value of the asset (plus finance charges) during the contract period. At the end of the lease, the asset is sold to a third party and the lessee can receive a share of the sale proceeds (if the lease is not being extended). Generally, the lessee will not be able to become the owner of the asset at any time - unless a private arrangement is made with the third party. However, there is usually the option to extend the lease and as the lessee will have paid for almost the full value during the initial lease period, the rental payments for subsequent periods will be minimal (sometimes referred to as "peppercorn rental"). Finance Leasing can be considered as similar to Hire Purchase, except that at the end of the repayment period, the user doesn't actually own the equipment. However, they can either: Return the equipment Continue to use the equipment in exchange for a small annual payment Sell the equipment to a third party at an agreed price The finance lease or 'full payout lease' is closest to the hire purchase alternative. The leasing company recovers the full cost of the equipment, plus charges, over the period of the lease. Although the business does not own the equipment, they have most of the 'risks and rewards' associated with ownership. They are responsible for maintaining and insuring the asset and must show the leased asset on their balance sheet as a capital item. When the lease period ends, the leasing company will usually agree to a secondary lease period at significantly reduced payments. Alternatively, if the business wishes to stop using the equipment, it may be sold second hand to an unrelated third party. The business arranges the sale on behalf of the leasing company and obtains the majority of the sale proceeds. Although a finance lease will look and feel the same as a hire purchase, one will not end up owning the asset at the end of the contract. Ownership remains with the finance company at all times. The agreement is structured so that the lessee pays off the whole value of the asset. If leasing a car worth £10,000, the lessee will pay the whole £10,000 plus interest during the lease. If they are still using the asset at the end of the original contract, a second agreement can be entered. This secondary agreement will be for a nominal fee. The lessee will be able to offset rental charges against profits and be able to claim VAT as well. The agreements can be structured in different ways but the broker may find that the lessee can choose when to sell the asset and, if so, get a rebate for the remaining rental charges. Operating Lease: A "Rental" facility where the lessor claims the tax allowances and takes a real risk in the residual value of the assets being financed. Under the terms of accounting standard SSAP21 the lessor derives their profit from the disposal of the goods, with the customer having a "rental" to offset against Profit & Loss Account. The assets are never shown on the customer's balance sheet. VAT is charged on the rentals and is reclaimable. Often with a shorter time frame than financial leasing (always significantly shorter than the working life of the asset), operating leasing is more like a regular rental. The lessor expects to be able to either sell the asset in the second-hand market or to lease it again and will therefore not need to recover the total asset value through lease payments. There may be an option to extend the leasing period at the end (this negotiation can only take place at the end of the initial rental period). As with finance leases, the user will not be able to become owner of the asset at any time but, contrary to financial leases, they will not share in the sale proceeds. If a business needs a piece of equipment for a shorter time, then operating leasing may be the answer. The leasing company will lease the equipment, expecting to sell it second hand at the end of the lease, or to lease it again to someone else. It will, therefore, not need to recover the full cost of the equipment through the lease rentals. This type of leasing is common for equipment where there is a well-established second hand market, such as cars and construction equipment. The lease period in this case will usually be for two to three years, although it may be much longer, but is always less than the working life of the machine. The business would not enter an operating leased asset on its balance sheet as a capital item. Contract Hire: A form of operating lease (often used with cars and other vehicles) that includes a number of additional services such as maintenance, management or replacement if asset is in repair. Contract hire is a form of operating lease and it is often used for vehicles. The leasing company undertakes some responsibility for the management and maintenance of the vehicles. Services can include regular maintenance and repair costs, replacement of tyres and batteries, providing replacement vehicles, roadside assistance and recovery services and payment of the vehicle licences. This offers the user an opportunity to have the use of a piece of equipment, often tied in with a maintenance contract, for the duration of the agreement. Ownership remains with the finance company and the customer will pay a set fee over a period to use that equipment. The contract will outline a residual value at which the finance company will take back the equipment at the end of the contract. A client could find this cheaper than a finance lease. If, for example, they wanted to buy a lathe for £10,000, a finance lease would be structured to pay off the whole amount plus interest over a period of, say, five years. However, under contract hire, the contract will specify a residual value that the goods will be worth at the end of the lease. Using our example of a £10,000 machine, the contract may specify a residual value of £2,000 at the end of a five year lease. The user will pay a total of £8,000 plus interest for the use of the asset during that time. For this reason, maintenance can be tied in to the contract to ensure that the asset will have the required residual value. One of the big benefits of contract hire to a small business is that there is no large capital outlay for equipment that could damage the company's balance sheet. While a business needs certain equipment, through a contract hire agreement only the rental charges will be shown on the balance sheet which should make it more attractive. Lease Purchase: As hire purchase, except for the repayment profiles which are usually a number of monthly or quarterly rentals in advance. e.g. 3+33 on a 36 month agreement. Additionally there can be a deposit at the front end together with a monthly rental, and at the back end there can be a "Balloon" or lump sum payment approximately equal to the expected resale value (if appropriate). The customer retains the sales proceeds Hire Purchase: An ownership facility, providing the customer with tax title to the goods and therefore the appropriate writing down allowances & sales proceeds - whilst deferring the cost over a period of time, usually 1-5 years. Additionally the customer is able to offset interest & reclaim all the VAT. Repayment profiles are usually a deposit, being a percentage of the cash price e.g. 5-20% + the VAT, followed by equal monthly repayments. Interest can be fixed or variable. The customer retains the sale proceeds at the end of the lease period or at the end of the asset’s working life. This is an agreement for the hiring of an asset with an option to purchase. The legal title will pass to the lessee when all payments have been made. The term of a hire purchase must be significantly shorter than the working life of the asset. The lessee is are able to claim capital allowances as if they had purchased the asset outright, gaining immediate use of it. Hire Purchase agreements are typically written for domestic users, not so much for business users. Hire Purchase is a variation of lease purchase; most people will have come across this at some point in the High Street. Whether one is considering buying a car or a television, hire purchase is widely available. It allows the user to pay off the full amount over a defined period. At the end of that period, provided they stick to the terms of the agreement, they will own the asset. There is a capital allowance – currently 25% on the reducing balance – available under a hire purchase agreement. If a business is registered for VAT, it can also claim back the VAT on the asset upfront. Also, any interest that it pays can be offset against profits. At the end of the agreement, they will own the asset. However, despite this hire purchase is far less common in business transactions now than ten years ago. Generally, if the user sees it as an asset that will keep its value, hire purchase is the option. However it does depend on what the user or client wants to do with the asset. Most businesses want to use but not necessarily own the equipment. In fact, small businesses are increasingly relying on full-service leasing contracts that allow them to use the asset without any of the hassles of ownership. The trend has spread from cars and vehicles, but is growing in other areas, such as IT. Small companies, in particular, do not have time to keep up to date with all the latest technology and what products are on offer. Instead, they can bundle the service in with the lease and ensure that somebody else keeps up to date for them. There is another reason that small businesses may have turned away from hire purchase. A startup business that has yet to turn in any significant profits may not be able to make best use of capital allowances. Instead, the bank or finance company can take advantage of those allowances and pass on the benefit through lower rentals. End of Lease Options At the end of the lease term, there are various options. Lease contracts can stipulate that the lessor return the asset; have the right to act as an agent to sell the asset to an independent third party; and/or can renew the contract or enter into secondary periods. It is important for the customer to anticipate future needs as each option has its advantages and disadvantages and will affect their monthly payments. Choosing the Right Type of Finance All types of financing offer different advantages and it is important that you assess your clients' circumstances and needs before committing them to a specific finance contract. For example: if they want to own the asset straight away, an outright purchase (cash or loan/overdraft) might be appropriate; if they may want to own the asset at some point in time and want to take advantage of instalment payments, hire purchase might be the best option; if they do not want to own the asset at all but require it for most of its useful life, consider a financial lease; and if they require the asset for a period of time significantly shorter than the useful life of it, consider an operating lease. Advantages of leasing Better Cash Flow. Leasing gives access to the asset with minimal up-front payments and spreads the cost over time. The user pays for the asset with the income it generates while minimising the drain on working capital No debt. An operating lease preserves credit options and does not influence credit limits as it is generally not classified as debt but as expense (note that this advantage does not apply to finance leases!) Maximise Financial Leverage. A lease can often finance everything related to the purchase and installation of the asset and may free up cash flow to pay for items such as training Simplified cash flow management. Lease payments are usually flat, making cash management more predictable and easier than with a variable rate loan. The fixed interest rate of a lease also helps if interest rates rise Tax advantage. Operating lease payments are generally tax deductible just like depreciation charges but are made with pre-tax money. Cash purchases, in contrast, are made with after-tax money. Hire purchase agreements allow the lessee to claim capital allowances Flexible time frames. Leasing contracts can be structured to fit your client's requirements. Use an asset as long as they need it without owning it forever Hedge against obsolescence. Depending on the end-of-lease option, the lessee can just return the asset to the lessor. They will not have the hassle of selling the used asset or run the risks related to residual value and (technical) obsolescence Additional advantages. Some leases offer additional advantages such as cancellation options or asset maintenance. Disadvantages of leasing. More expensive. A finance lease is usually more expensive than an outright cash purchase as the payments include finance charges. However, leasing may cost less than other forms of financing. Also consider the tax advantages when making this calculation Additional Guarantees. Depending on the credit rating of your company, the lessor might require additional guarantees. These may be provided by the lessee, business partners or the bank and could affect personal credit rating or business standing with the bank Fixed Term. It may be impossible, or at least costly, to terminate a leasing contract early Fixed Interest Rates. Interest rates are usually fixed throughout the lease which may prove a disadvantage in times of falling interest rates. Things to watch out for: Return of Asset Conditions. If the user chooses to return the asset at the end of the lease, the condition in which and the place where it must be returned are important aspects to consider carefully Notice Period. If a lease includes the option to renew take note of any time periods in which to give notice in case the lessee does not want to renew the contract. Some leasing companies will automatically renew the contract if the lessee fails to give notice Purchase Rights. If negotiating the right to purchase the asset at the end of a lease, a predetermined fixed price offers more value as the 'fair market value', which theoretically is always available to your client Maintenance Responsibility. Clarify which service and maintenance programs are included in the lease. If your clients are responsible for service and maintenance, make sure they do not have to provide an unreasonably high degree of it.
		© Aberdeen Industrial Finance 2008