In an earlier article, we discussed the concept of asset replacement planning concerning owned non-current (fixed) assets. There is of course another way to go about acquiring assets for business purposes and that is leasing. Leasing is sometimes, understandably confused with hiring but the two are quite different and we will get into this later. Leases themself also have distinctions which we will touch on. Due to many factors leasing isn’t quite spoken of in the right light when it comes to small businesses but I’d like to make the case for leasing.
A lease is a contract by which one party conveys land, property, services, etc. to another for a specified time, usually in return for a periodic payment. I do prefer the accounting definition as per International Financial Reporting Standard (16) a lease is defined as a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. The emphasis on the right to use the asset is important. One example we can all easily understand is a rental lease on land or a building. The lessee (renter) enjoys the use of the property but never owns the property. Land and buildings generally last very long. What I would like to draw attention to today are leasing assets that have shorter useful lives such as machinery, plant and equipment.
Types of leases
There are many types of leases but for our purposes, we will group these types of leases into either operating or finance leases. This distinction matters in a few cases. We will not go deeply into where and why it matters but what we need to do is understand the distinction. There are many differences we can pick between an operating lease and a finance lease but the most important one comes down to ownership of the asset particularly at the end of the lease. An operating lease gives the lease the rights to operate the asset but ownership remains with the lessor even at the end of the lease period. A finance lease on the other hand has an option or obligation for the lessee to take ownership of the asset at the end of the lease period. The finance lease is therefore a method of spreading the finance cost of an asset with the assistance of a lessor. Both these types of leases are viable in the world of non-current assets.
The case for leasing
Hopefully, we understand leases well enough that we can now look at the advantages that leasing non-current assets present to us as people in business.
Non-current assets tend to represent a major investment of funds. Leasing these assets has a capital p[reservation effect. Buying a $15000 asset upfront and leasing the same asset for $2000 a year have very different capital and cash flow implications for the business.
This is closely related to the idea of capital preservation but looks at it from the resource constraint perspective. For many businesses and small ones in particular having $15000 ready to plough into the asset is only a dream. However, through leasing, the business can convince a financier to help with the lease and the business has an obligation to make a payment of $200 which may well be within the reach of the business.
Let us continue without the $15000 asset example. Let’s assume the asset will result in the business earning $2500 a year from its usage. While at the end of the 5 years the net result (ignore discounting) will be a net cash inflow of $2500 ( $12500-$15000) whichever way you look at it, if you acquired the asset through a finance lease the cash outflow in year one ($2000) would closely match the inflow ($2500) in the same year and every year thereafter
Leasing of course offers greater flexibility especially in the case of operating leases. While leases tend to be for fixed predetermined periods you can always if the need arises make adjustments. Say for example your business requires more space to accommodate a bigger staff complement or expand production. You can simply break the existing lease and lease property that is adequate for your needs. The same can be applied to machinery and equipment. If there is a change in production processes thanks to new technology you are free to take advantage of it as you are not bound to the asset.
More Purchasing Power
When we looked at financial efficiency we ignored discounting. Now let us look at the impact of discounting on leasing. The concept of discounting is something Zimbabweans will be extremely familiar with given the catastrophic devaluation the Zimbabwean dollar has suffered. A dollar today is worth more than a dollar a year from now. We can put this into perspective using the Zimbabwean dollar official exchange rate which valued one Zimbabwean dollar at around US 4 cents a year ago and only US 1.2 cents today. In theory, the leasing arrangement for our $15000 asset is beneficial as it defers the payment for the asset and therefore allows us to take advantage of the purchasing power of our remaining $8000 ($15000-$2000) today.
Are there drawbacks to leasing? Yes. Chief amongst them is having to convince an intermediary or lessor that you qualify for the lease. That said leasing still makes a great lot of sense for businesses.