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Leasing is a form of financing in that it enables the lessee to obtain the use of the equipment without directly incurring any debt obligation. By Daniel P. Duffy The American Equipment Leasing (AEL) Commercial Finance Group provides equipment leasing throughout various industries and municipalities. Its representatives have the knowledge to help meet customers' equipment needs while attaining long-term fiscal management objectives. Its Master Lease Program assists customers in acquiring capital equipment from multiple suppliers while benefiting from a single fixed monthly lease payment. This program simplifies administration of the equipment purchasing and lease/finance processes. The Master Lease Program is built around the Master Lease Letter Agreement; it affords the time needed to make equipment acquisitions from multiple suppliers over a several-month period, if necessary. AEL also offers competitive lease/finance rates and options. Once a customer's financials have been reviewed and its lease documents are in order, the customer may utilize its lease/finance line of credit to make purchases with AEL purchase orders while paying only a partial lease payment on the equipment delivered and accepted by the customer and paid for by AEL. Then, once the buying period is complete, the partial lease payment is eliminated and lease payments go into effect. Leasing Types and Terms Leasing is obtaining the use of specific equipment and other assets without actually taking title to them; a contractor may rent equipment for a specified time period under a contract called a lease. The operator under this agreement is called the lessee and the supplier of the equipment is referred to as the lessor. The right to use the equipment is called the leasehold. Payments made by the lessee to the lessor are known as rents. Leasing is a form of financing in that it enables the lessee to obtain the use of the equipment without directly incurring any debt obligation. There are two basic types of leases: operating and capital. Operating Lease Under an operating lease, the lessee pays only for the use of the equipment for a set period of time. During this time period, the lessor retains the usual risks and rewards for owning the equipment. Often long-term leases require advance payments that are held in a leasehold account until the future payment period. Sometimes the operating lease agreement makes provisions, allowing for improvement of the equipment by the lessee (leasehold improvements), though this usually applies to the lease of property. More applicable to equipment leasing are the maintenance costs incurred by the lessee (assuming there is no separate warranty agreement requiring the lessor to provide for repair and maintenance), which can be covered by similar lease provisions. The costs of improvements, or maintenance and repair, are amortized over the time of the lease or the projected lifetime of the improvement, whichever is shorter. In any case, the lessor maintains ownership of the equipment at the end of the lease period. Operating leases tend to be short term (five or fewer years) and cancelable by either party. Capital Lease In contrast to the operating lease, the capital lease transfers substantially all the benefits and risks related to ownership. This can be done several ways:
In effect, a capital lease is similar to an installment purchase. Capital leases tend to be long-term (more than five years) noncancelable agreements. Also keep in mind that the total payments over the capital lease period are greater than the cost of the equipment to the lessor. This makes it important to closely align the lease period with the operating lifetime of the equipment. Advantages of Leasing The advantages of leasing are many: improved financial ratios; effective depreciation; increased liquidity; effective 100% financing, without the need for down payments; bankruptcy protection; avoidance of obsolescence; lack of restrictive covenants; and financial flexibility. Effects on Financial Ratios Since leasing results in service from a piece of equipment without increasing either the assets or liabilities on the operator's balance sheet, this might result in misleading financial ratios. It does not apply to capital leases, although with operating leases, this remains a potential advantage to the operator. The operator, however, is usually required to disclose the lease in a footnote to his company's financial statement. Accountants analyzing the firm's balance sheet will make equivalent adjustments to the firm's assets and liabilities. Increased Depreciation Since the lessee is permitted to deduct the total lease payment as an operating expense for tax purposes, the cumulative effect is the same as if the operator purchased the equipment and then depreciated it. The greater the value of the equipment leased, or the size of the equipment fleet, the greater this advantage. However, this is offset by the fact that the lessor still retains ownership (at least with an operating lease) and can take advantage of any salvage value. Increased Liquidity Lease agreements also can be structured as sales-leaseback arrangements. In this case, an owner of a piece of equipment sells the equipment to a lessor, who then leases it back to its former owner, who is then the lessee. In effect, the previous owner has converted an existing asset into cash that can be used as working capital to overcome a liquidity squeeze. Naturally, the previous owner is now liable for a fixed series of lease payments that will affect future liquidity. Effective 100% Financing Since most loan agreements require borrowers to make a down payment on the purchase price of the equipment, the borrower receives only 90-95% of the purchase price of the asset. In the case of a lease, however, the lessee is not required to make any type of down payment. In effect, this provides the lessee with the equivalent of 100% financing. The operator can therefore receive the use of the equipment for a much smaller initial out-of-pocket expense. If the lease does require a large initial advance payment, however, this should be considered a kind of down payment. Limited Claims in the Case of Bankruptcy Bankruptcy laws limit the amount of claim a lessor might have on a bankrupt lessee. If a lessee declares bankruptcy, the lessor is limited to the cash equivalent of only a few months' worth of lease payments. On the other hand, a bankrupt purchaser is liable to his lender for the total amount of unpaid financing. The amount of salvage value at the time of bankruptcy will determine the better situation for the operator. Avoid the Risk of Obsolescence With operating leases, which tend to have short lives, the lessee can completely avoid the risk of equipment obsolescence. For capital leases, the lessor must be very careful in setting the lease payments accurately to anticipate the equipment's future obsolescence, though most lessors are savvy enough to avoid this problem. Besides, most construction equipment is not subject to obsolescence concerns; bulldozer technology, for example, hasn't changed much in the past few decades. What is of greater concern are the electronics guiding the equipment. A global positioning system (GPS)—guided dozer might have its hardware and software made obsolete by new equipment, software upgrades, or mergers among the supplier firms. Lack of Restrictive Covenants A lessee avoids most restrictive covenants that are usually part of a long-term loan; these are financial and operating constraints imposed on the borrower by the lender to ensure that future payments are made. They can include requiring the borrower to maintain a minimum level of working capital, prohibition against the liquidation of fixed assets, limits on future borrowing, prohibition against entering into a lease, and management restrictions (e.g., maintaining certain key employees). Flexibility Provided In the case of equipment that is infrequently acquired, operating leases might provide a firm with much-needed financial flexibility. Leases are easier to obtain than loans and run for shorter periods of time, and there is no need for the owner to present collateral. The ability of a lessee to obtain equipment without resorting to financing preserves his ability to raise funds for the acquisition of more costly assets. Disadvantages of Leasing There are also several potential disadvantages to leasing: high effective-interest costs, lack of salvage value, difficulty of making improvements, and the effects of obsolescence. High Effective-Interest Costs Though a lease does not carry any explicit interest expense, the lessor builds-in a return for himself into the lease payments. Given the risks inherent in the construction industry, the lessor is usually justified in setting the implicit rate of return quite high. The risks involved are largely due to fluctuations in economic cycles and subsequent construction activity (or lack thereof). Equipment inventory that is not being leased represents a potentially heavy cost burden on the lessor. As a result, the lessee might be wiser to purchase the equipment, especially for long-term use. Lack of Salvage Value At the end of its useful life or lease term, the lessee has nothing to show for the equipment that he must now divest. Any resale or salvage value (even value as scrap) is realized by the owner/lessor. This is true even for equipment that does not depreciate in value over time and might represent a significant opportunity cost to the lessee. For capital leases with an option-to-buy provision, this disadvantage might not exist. Difficulty of Improvements During the period of the lease, the lessee is usually prohibited from making improvements on the leased assets. While this typically is not a factor for the "iron" part of the equipment (dozer blade design hasn't changed that much in the past few decades, for example), it can be important for the electronics part of the equipment. As previously mentioned, GPS drivers and their software are constantly being improved and upgraded. A lessee typically cannot take advantage of such improvements when they occur or could find himself with an equipment fleet operating with different electronic controls tied to different GPS systems. Obsolescence Consideration Again, short-term leasing usually protects the lessee from the effects of obsolescence. Should such obsolescence occur, however, the lessee might find himself at a competitive disadvantage with other firms using more up-to-date equipment, and the resultant increase in production costs will hamper the lessee's ability to bid on projects successfully. Subleasing The potential for subleasing equipment, unlike fixed assets such as office space, is very limited. First, unless the equipment is idled as a result of a slowdown in construction activity, it usually makes more sense financially for the lessor to use his equipment productively in the field. If there is a general downturn in construction activity, however, there won't be many other firms interested in an equipment sublease. Second, subleasing can lead to a daisy chain of complications involving maintenance agreements, rental payments, tax considerations, and insurance coverage. For this reason, most primary lessors do not allow the subleasing of their equipment. Author Daniel P. Duffy, P.E., is an environmental engineer for Rumpke Waste Inc. in Cincinnati, OH. Part 3 of this article series will compare leasing and financing and will discuss how to evaluate either option. To read Part 1 click here |
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