Benefits and Limitation of Leasing

Benefits and Limitation of Leasing

Leasing is basically a contractual agreement between a renter and an owner. For example, the landlord and the tenant. Leasing can be defined as a deal by which one can get the use and control over and assist without buying the asset. So, by this arrangement, one can use the asset without owning it. This is a contract between the lessor and lessee, where the lessor gives the right to use the asset to the lessee for a specific period of time and on the payment of some amount. Consideration called rentals. The lessee pays these lease rentals on a regular basis, say yearly, halfyearly or quarterly, depending upon the agreement between the lessor and lessee. The determination of lease rental can be on the basis of profits of the lessor and the time of the lease agreement.

After the expiration of the time for the contract, the underlying assets slip back to the lessor but in some cases, the lessee has the option to buy it or renew its lease agreement.

Benefits of the lessee

1. A simplesource of finance

Benefits and limitation of Leasing

Leasing is an easy source of intermediate and long-term finance. As the owner of the asset lies with the lessor, so this lease does not require any security for the asset. Various types of provisions are applicable when one asset is purchased with long-term loans from financial institutions. So, a lease can be defined as an easy and simple source of finance.

2. Does not involve an initial cash outlay

A lease agreement allows a lessee to use an asset without buying it. lease financing can go up to 100 percent. In some cases, the first amount of lease rental is required by the lessor in advance. However, all most all type of lease agreements involves a small amount of initial cash outflow. Due to this reason leasing is used to finance capital goods which involve a huge amount of investments like building, land, machinery etc.

3. Involves less cost

Leasing involves less amount of initial money; it costs less than the other sources of financing like loan, debt or equity.

4. Risk of obsolescence of assets

A lessee can reduce its risk of obsolescence by shifting it to lessor because the ownership of the asset lies with the lessor. So a lessee can shift such risk.

5. Does not involve conditionalities

Lease financing is preferable to institutional finance because it avoids conditionalities in the use of assets. An institutional accounting and finance and term loans from bank involve some conditions on the use of loan amount. Leasing, however, does not involve such type of risks.

6. Effect if borrowing capacity of lessee

Lease financing does not affect the borrowing capacity of the lessee. As lease financing is like a hidden form of debt for the lessee, he is supposed to show it on the balance sheets.

7. Flexibility in the determination of lease rentals

Lease contracts are so structured that the lessee can pay lease rentals out of the funds generated from the assets. These can be determined on the equal basis, including deferment period, stepped rental, etc. so that there is flexibility in the determination of lease rentals which levies a lesser burden on the lessee.

8. The higherrate of return on capital employed

A leased asset is not placed on the asset side of the balance sheet of the lessee, even though this asset definitely contributes to the profits of the company. This leads to a higher rate of return on capital employed.

9. Tax-relatedbenefits

The lessee can make changes in the lease amount to modify its net profits. If the taxable income of the lessee is higher, then he can go for a higher amount of lease rental.

Benefits to the lessor

1. A higherlevel of security

Benefits and limitation of Leasing

The lessor's interest always secure in lease financing as the ownership lies with the lessor, only the right to use is transferred to the lessee. Inh case the lessee is not able to pay lease rentals, then the lessor can repossess the asset as he is the legal owner. By means of this right, the lessor is always secure.

2. Earn higher profits

The lessor can earn higher profits as the lease rental is always higher than the total amount of money invested in the asset which increases the profits of the lessor.

3. Growth potential of leasing industry

Various benefits related to lease financing analysis helps the economy to grow further which again boosts the leasing industry because one can use assets without owning them and others can loan them without losing control over them. This situation is beneficial to all the parties involved in the lease arrangements. So the business of the lessor can grow in an economic depression also.

Limitations of lease financing

1. Involves higher costs

Lease financing involves a higher cost to the lessee as lease financing has less initial investment by the lessor than the lease rentals. It is beneficial to the lessor not to the lessee.

2. Risk of taking away assets by the lessor

In lease financing, a lessee is always prone to the risk of the asset being taken away in case the lessor faces bankruptcy or the leasing company winds up.

3. Loss of salvage value

Every long-term asset has value at the expiry of its life which is known as salvage value. The lessor as the owner of the asset has the right to this salvage value, not the lessee who uses the asset for its entire life. The lessee has to return this asset to the lessor who realizes its salvage value.

4. The badeffect of price level changes on the lessor

The lessor bears the negative effect of price level change. As the amount of lease rental is fixed, and when the cost of the asset increases due to the inflation, the difference is born by the lessor and not by the lessee.

5. Effect of termination of the lease contract

Benefits and limitation of Leasing

If the lessee terminates the lease contract before the expiry of the lease time he has to pay huge amount penalties to the lessor to compensate for the latter’s loses due to this termination.

6. Huge competition in the market

Leasing is becoming a successful business in recent years, so a leasing company has to face stiff competition from domestic as well as foreign companies. This competition may lead to less amount of lease rental for the lessor decreasing his expected profits and instead, he has to bear more risk.