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Difference Between Finance Lease Vs Operating Lease

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Lease is the most common concept in business regardless of which sector your company belongs to. It is a financial agreement in which the owner of the property, known as the lessor, agrees to rent it to you (the lessee). A legal contract standardises the lease terms and agreement, protecting the interests of all parties involved. The two most common types of lease financing are: finance and operating. In this article, we will learn not just the meaning of these lease agreements but their differences as well.

What is a Finance Lease?

Finance leasing, also known as capital leasing, is a contract that allows you to use a specific asset for a predetermined period. Under financial leasing, the lessor retains the asset title, and only the risk and reward are transferred to you as the lessee. 

Once the agreement reaches expiry, the ownership is retransferred to the lessor. Financial leasing allows you to purchase the asset in question for a lower price than its fair market value. It further allows you to claim a tax deduction for interest payments and depreciation. However, this type of lease usually cannot be cancelled before the expiry date. 

How Does Financial Lease Work?

Assume you have started a manufacturing plant and need large plants and machinery for your operation. Since buying these machineries and plants can be a huge cost to bear in the initial stages of the business, you can get them on the lease for 40 years. 

Given the length of the agreement, you may have paid nearly all of the initial purchase price of the asset. And, because plant and machinery depreciate over time, the lessor gives you the option to purchase the capital asset at a nominal cost.

Features of Financial Lease

  • Bargain Power: The lessee has the option to purchase the asset at a nominal value that is significantly less than the asset's fair market value.
  • Tenure: The holding tenure in a financial lease is typically greater than 75% of the asset's shelf life.
  • Present Value: By the end of the lease, the lessee has typically paid 90% of the asset's original cost.

Advantages and Disadvantages of Finance Lease

A finance lease provides both benefits and drawbacks for businesses. Understanding these can help in making informed leasing decisions.

AdvantagesDisadvantages
Ownership Transfer: Asset ownership transfers at lease end.Higher Cost: Often more expensive than purchasing outright.
Tax Benefits: Lease payments may be tax-deductible.Long-term Commitment: Locked into payments for the lease term.
Fixed Payments: Predictable budgeting with fixed lease payments.Maintenance Responsibility: Lessee is responsible for asset maintenance.
Improved Cash Flow: No large upfront payment required.Depreciation: Lessee bears the risk of asset depreciation.
Access to New Equipment: Up-to-date technology without full purchase cost.Limited Flexibility: Harder to end the lease early without penalties.

Also Read: Mistakes That First-Time Small Business Loan Recipients Make

What is an Operating Lease?

The operating lease is flexible in nature, allowing the lessee to cancel the contract before the due date. The lessor allows the lessee to use the asset in exchange for rent for a period much shorter than the asset's shelf life under this contract. In contrast to financial leasing, the asset owner does not transfer ownership rights to you under operational leasing.

How does Operating Lease work?

Suppose you own a restaurant in an area where there will remain a major power outage for a few months. Because you are unable to supply power for the refrigerator and other necessary appliances, any leftover ingredients or other perishable raw materials quickly deteriorate. 

To deal with this, you intend to install a generator, but due to its high cost, you abandon the idea and instead intend to lease the generator and pay rent for it. The lease expenses are recorded in the profit and loss statement.

Features of Operating Lease

An operating lease offers flexibility and benefits for businesses needing equipment without owning it.

  • Short-term Agreement: Typically, operating leases are for a shorter duration compared to finance leases.
  • Off-balance Sheet Financing: Lease payments are treated as operating expenses, not affecting the balance sheet.
  • No Ownership Transfer: The asset remains with the lessor at the lease end.
  • Lower Maintenance Responsibility: Lessor often handles maintenance and repairs.
  • Flexible Terms: Easier to upgrade or return the equipment as needed.

Advantages and Disadvantages of Operating Lease

An operating lease provides both benefits and drawbacks for businesses. Knowing these can guide better leasing decisions.

AdvantagesDisadvantages
No Ownership: No worries about repairs or maintenance costs, as you can use the assets without bearing ownership responsibilities.No Equity: You don't have equity in the leased asset, and in a financial emergency, you can't sell it.
Cost Eeffective: Beneficial for new businesses as you pay a small rent and return the asset, improving cash flow and lowering operating costs.Higher Costs: Extended leasing can result in paying more than the asset's fair market value over time.

Also Read: Financial Tips To Set Up A New Business

Difference Between Finance Lease and Operating Lease

Understanding the differences between a finance lease and an operating lease can help businesses choose the right leasing option.

ParametersFinancial LeaseOperational Lease
Type of ContractIt acts as a loan agreement.It acts as a rent agreement.
TenureLong termShort term
TransferabilityOwnership right is transferred to the lessee, with the lessor retaining the title.Ownership is not transferred.
RevocationCancellation is not permitted once the contracting parties have entered into the financial lease agreement.Contract revocation on legitimate grounds is possible during the first few months.
Tax BenefitsYou can claim tax benefits on depreciation, financing charges, and any other amount spent on the asset's repairs and maintenance.Tax benefits are available for rent you paid to use the asset.
OptionAt the end of the lease contract, the lessor provides you with an option to buy the underlying asset at a much lower price than fair market value.There will be no purchase offer made to you.
Obsolescence RiskIt lies with the lessee.It lies with the lessor.
MaintenanceThe lessee is responsible to take care of the maintenance of the underlying asset.Maintenance lies in the hands of the lessor.
AccountingIt is recorded in the assets and liabilities of the balance sheet.It is recorded in the profit and loss statement of your business.

What are the Alternatives to Leasing?

Businesses usually opt for a lease, either if they are facing a cash crunch and cannot make an outright purchase of an asset, or if they need a particular asset for a short period. If you face the former challenge, instead of leasing, consider a business loan. A business loan is a financing product tailored to your specific need. If you want to invest in a capital asset, you can choose an equipment financing loan with a longer repayment period and a larger loan amount. A term business loan may be an option for equipment that does not require a large investment.

Also Read: Have you tried these 11 ways to improve cash flow in your business

Conclusion

The primary distinction between a finance lease and an operating lease is one of tenure. The former is a long-term agreement. Moreover, under financial risk, the lessor transfers the ownership right, which is not the case with the operating lease. Simply put, if you need an asset for a long time and believe that the financing cost will not exceed the asset's market value, a financial lease is a way to go. Otherwise, you always have access to a low-interest business loan.

Frequently Asked Questions

1. What are the tax benefits of a Finance Lease?

In a finance lease, the lessee may benefit from tax deductions on depreciation and interest payments, which can reduce taxable income.

2. What are the tax benefits of an Operating Lease?

Lease payments in an operating lease are typically tax-deductible as operating expenses, which can help reduce the overall taxable income.

3. How does a Finance Lease affect cash flow?

A finance lease involves higher monthly payments as it covers the full value of the asset. However, it allows for asset use without a large upfront payment.

4. How does an Operating Lease affect cash flow?

An operating lease generally involves lower monthly payments, making it cost-effective and improving cash flow. It also avoids the need for a large initial investment.

5. Which lease option is better for a new business?

Operating leases are often better for new businesses due to lower initial costs, flexibility, and reduced long-term financial commitment.