What is a Finance Lease?
A finance lease, also known as a capital lease, is a leasing arrangement in which the lessee (the party who leases the asset) pays for the use of the asset over the lease term. At the end of the term, asset ownership passes to the lessee.
With a finance lease, you own the asset at the end of the term.
What is an Operating Lease?
An operating lease is an arrangement in which the lessee pays for the use of the asset over the lease, but at the end of the term, ownership of the asset remains with the lessor. An operating lease is mainly used for equipment with a shorter useful life, such as office furniture or vehicles.
An operating lease is like renting in that you are leasing the asset from a separate party who rents the asset out to you but keeps ownership of it. It may differ from ordinary renting because most of the risk lies with the lender rather than the lessee. This may depend on the lender you go with. Still, the lessee is generally only required to pay the lease payments, whereas, with a finance lease, the lessee pays all the expenses. This could include insurance, maintenance, taxes and any additional administration fees on the asset.
Operating leasing is similar to general equipment finance, the main difference being that the lessee has no intention of purchasing the asset once the lease period is up.
An operating lease is similar to renting. The lender owns the asset, and you lease it from them for a set period before returning it.
The Key Differences Between Finance and Operating Leases
The key difference between finance and operating leases is that with a finance lease, the lessee pays for the asset's use over the lease term. At the end of the term, asset ownership passes to them. On the other hand, an operating lease's ownership of the asset remains with the lessor.
A finance lease appears on the company balance sheet as a depreciating asset. A finance lease shows on the balance sheet because when the business gets the asset, the rights' ownership is transferred to them. In contrast, an operating lease is not shown as the firm does not own the asset, nor will they have the opportunity to. An operating lease is sometimes known as off-balance sheet financing. For this reason, a finance lease can be seen as a debt, whereas an operating lease is not.
An operating lease is often cheaper than a finance lease as the cost is based on the use of the asset but over a much shorter period. This is because, with an operating lease, you are only paying for the use of the asset and not the entire purchase price.
One of the main differences between a finance and an operating lease is that a finance lease shows up on the company's balance sheet, whereas an operating lease doesn't.
When a finance lease is up, the lessee owns the asset outright, whereas, with an operating lease, ownership remains with the lessor. If you enter an operating lease, you will need to negotiate a new lease agreement or return the asset.
Finance leases tend to be used for more extensive and expensive assets. Oppositely, operating leases are more common for smaller items.
Benefits of a Finance Lease
There are several benefits of a finance lease.
- It can provide a way for a business to acquire an asset without having to tie up large amounts of capital.
- It can help spread an asset's cost over its useful life, making budgeting simpler.
- At the end of the term, the business will own the asset outright.
- The lessee can reduce their taxable income by claiming depreciation on the asset.
Drawbacks of a Finance Lease
There are also some possible drawbacks associated with a finance lease. With a finance lease, you are responsible for the upkeep and maintenance of the asset. So, if you don't keep up with the maintenance, it could cost the business more in repairs than if you had purchased the asset outright.
You are responsible for the maintenance of the asset, so you should be aware of this as this could cost you more in the long run.
Benefits of an Operating Lease
Several benefits can be associated with an operating lease.
- It can provide a business with the use of an asset for a set period without purchasing it outright. This can save the business money upfront and free up capital for other purposes.
- An operating lease can help spread an asset's cost over its useful life, simplifying budgeting.
- At the end of the lease term, the business will have the option to renew the lease or return the asset to the lessor. There is less commitment to this. The business is given more freedom as by having the option to return the asset to the lender, they can update their equipment more frequently and stay updated with new technology.
Drawbacks of an Operating Lease
There are also some potential drawbacks linked to an operating lease. You don't have any claim over the asset despite making payments. While this gives you freedom, you may decide you want to own it at the end of the lease, but you must return it to the lender. You can renew the lease, but ultimately it will still be the lender's property. Conversely, you are committed to making payments until the end of the lease, so if you decide halfway through the term that you no longer want the asset - you still have to pay for it until the term is up. If you get the asset over a long period, it may be cheaper to buy it outright. However, an operating lease tends to be short-term.
An operating lease is generally a type of short-term finance.
If the business experiences financial difficulties, it may struggle to make the lease payments and could ultimately default on the lease. This could lead to repossession of the asset by the lessor. This outcome could occur with both a finance and operating lease.
Which Option is Better for My Business?
The best option for your business depends on several factors: including the type of asset being leased; how long you need the asset for; and the financial stability of your business.
A finance lease may be the better option if you need the flexibility of an affordable monthly payment. However, if you want to own the property outright or don't want the responsibility of repairs and maintenance, an operating lease may be a better fit.
If you are unsure which option is best for your business, it is advisable to seek professional advice.
You should weigh up your options when choosing which type of lease is right for your business. Each has pros and cons, which will suit different businesses respectively.
When deciding whether to opt for a finance lease or an operating lease, it is important to consider the type of asset being leased, the length of time that the asset will be needed, and the financial stability of your business. This article should provide you with all the necessary information; however, if you still aren't sure, you can call us any time, and one of our account managers will help you with your decision.