Benefits and Limitation of Leasing
Leasing is a contractual agreement between a renter and an owner. For example, the landlord and the tenant. Leasing can be defined as a deal in which you do not own the product but you make abundant use of it for your support. 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 and on the payment of some amount. Consideration is called rentals. The lessee pays these lessor rentals on a regular basis, say yearly, half-yearly, or quarterly, depending upon the agreement between the lessor and lessee. The determination of lease rental can be on the basis of the 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 simple source of finance
Leasing is an easy source of intermediate and long-term finance. As the ownership of the asset lies with the lessor, 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. In some cases, leasing may offer 100% financing, requiring no down payment or collateral other than the leased asset itself. Almost every type of lease agreement 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. Reduces risk
The leasing agreement often includes provisions for maintenance, repairs, and asset maintenance. This shifts the burden of the lessee to the lessor who is now responsible for incurring unexpected expenses, and downtime due to equipment breakdowns or obsolescence.
4. Easy approval process
Lease financing is a much easier process in comparison to other traditional loans or lines of credit. This is beneficial for businesses whose credible score is less or for those who want to save their credits for other business purposes.
5. Does not involve conditionalities
Lease financing is preferable to institutional finance because it avoids conditionalities in the use of assets. Institutional accounting and finance and term loans from banks involve some conditions on the use of loan amounts. Leasing, however, does not involve such types of risks.
6. Effect of the borrowing capacity of the 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, it is supposed to be seen on the balance sheets. Keeping leased assets off the balance sheet improves the financial ratios and increases the borrowing capacity for other investments or credit needs.
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 an 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 higher rate 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-related benefits
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 higher level of security
The lessor's interest is always secure in lease financing as the ownership lies with the lessor, only the right to use is transferred to the lessee. In 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 the leasing industry
Various benefits related to lease financing analysis help the economy to grow further which again boosts the leasing industry as one can utilize an asset without owning it and others can’t take a loan without losing control over it. 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.
4. Tax benefits: Lessors may benefit from various tax advantages associated with leasing, including depreciation deductions, interest expense deductions, and potential tax credits for certain types of leases. These tax benefits can enhance the lessor's after-tax profitability.
5. Investment portfolio diversification: By leasing a variety of assets as per the needs of various industries, a lessor can diversify their investment portfolio. This helps in spreading risk and minimizing the impact of changes in specific marketing sectors.
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. Leasing an asset for the long term results in higher cumulative payments than the actual value of the asset.
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 a 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 bad effect 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 inflation, the difference is born by the lessor and not by the lessee.
5. Effect of termination of the lease contract
If the lessee terminates the lease contract before the expiry of the lease time he has to pay huge penalties to the lessor to compensate for the latter’s losses due to this termination.
6. Huge competition in the market
Leasing has become 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 lease rental for the lessor decreasing his expected profits and instead, he has to bear more risk.
In Conclusion, a lessee should take effective measures to ensure that the decision regarding leasing an asset is worth it or not. While a lease offers various advantages such as cost benefits, flexibility, and risk reduction, it is crucial to understand and be aware of the potential disadvantages.
By understanding the advantages and disadvantages of leasing, businesses can make informed decisions that align with their business goals. Even after making an analysis, if you are unsure about your decision then you can take suggestions from experts, who can provide guidance to assist you with significant financial commitments