This article explains the differences between the two forms of asset acquisition. Then I’ll describe the overall cost for both forms of asset ownership and the advantages and disadvantages. Finally, I create a decision model for you to follow to make the best possible judgment between a lease and a purchase. This article is designed to educate the reader and therefore it is somewhat detailed in scope. When done, the reader should be able to understand the basic conceptual differences between leasing and buying the asset.
Differences between Leasing and Buying
This is one of those business decisions that can either save the owner a lot of money or wreak havoc on the cash of the company. There is no single correct answer, the key is to understand both options and use informed decision making processes to choose the best course of asset acquisition. To begin, let’s define the two terms.
This is the traditional method for asset acquisition. The company proceeds to negotiate the cost of the asset and either pays cash or pays a down payment and then finances the balance. The latter is the customary method for highly marketable assets such as automobiles, trucks, site development equipment, office equipment (copiers, furniture etc.) and farming equipment. If the borrowing of the funds fails to make a payment, the lender has a readily available market to sell the asset upon default.
Once the asset is purchased, the asset is considered titled in the company’s name. With title comes ownership responsibilities; these include regular maintenance, major repairs, insurance, property tax compliance and ultimately disposal of the asset once utility is complete.
The best part is equity value for those long term assets. A good example is a piece of machine shop equipment. There is value in this equipment long after the loan is paid and that fair market value is referred to as equity. On the balance sheet, the asset is most likely fully depreciated and therefore has a zero balance. However, in the real market, the asset may have thousands of dollars of value.
In the world of business, this is an age old form of real estate management. For personal property, it is a relatively new form of financing asset use. In this form of asset acquisition, the asset is actually titled to a financing company and they in turn rent the asset to a lessee. The transaction is very similar to any rental agreement. You provide some form of security deposit and some other upfront fees and then make monthly payments to use the asset. Just like renting real estate, the landlord (lessor) is responsible for the maintenance and taxes associated with the asset. Remember they have the title so they are technically responsible for insurance, property taxes, upfront sales tax, repairs and maintenance.
At termination, you hand the asset over to the lessor and you are done. The lessor inspects the asset and if you used it more than you agreed in the lease, the security deposit is adjusted. Any modifications or upgrades may or may not be retained by the lessor depending on the terms of your lease. You no longer have any rights to the asset. So as in the example for machine ship equipment used above, the fair market value or equity is held by the lessor.
In general, there are two types of leases.
Operating – very similar to a rental agreement, you agree to make monthly payments and these payments are recorded as an expense on your profit and loss statement. You have no rights to purchase or retain the asset beyond the lease term.
Financing Lease or Capital Lease – this type of lease has an option to buy the asset at the termination of the lease. The lessee may be able to purchase the asset for either an upfront agreed price, the fair market value at termination, or a nominal amount at termination. This option transfers title to the lessee upon termination. However, if the nominal fee is extremely low like $1 or $10, the title is implicitly passed at the beginning of the lease. The actual title will pass upon termination. These two types of leases are discussed in more detail in another article.
In a typical lease transaction, the manufacturer sells the asset through a dealer. The dealer has access to a financing company that will take on the responsibility of the lessor in the transaction. So upon a signed lease agreement with you, the dealer may or may not be in the picture in the future. In many cases, the dealer becomes the repository for the asset upon termination but the financing company is the actual bearer of title to the asset.
The overall primary difference is title ownership and final title ownership at the end of the agreement whether this is a loan in the buy format or a rent agreement in the lease format. The following chart describes the differences between the two formats throughout the arrangements or life of the asset:
|Title||You own the asset and get to keep it at the end of the loan amortization.||You don’t own the asset. You get to use it but must return it at the end of the lease. Some leases have an option to buy (Financing/Capital Leases).|
|Up-Front/Down Payment Amounts||They include the cash price or a down payment, taxes, registration and other fees.||Leases require some form of prepayment to cover a security deposit, first month’s rent, taxes, insurance if applicable, contract fee, and delivery charges. A typical upfront cost is in the neighborhood of 4 – 7% of the total lease cost.|
|Monthly Installments||Loan payments are usually higher than lease payments because you’re paying off the entire purchase price of the asset plus interest. Taxes and other compliance costs are typically paid separately from the loan payment.||Payments include interest on the entire asset value, straight-line depreciation, contract fees, taxes if applicable, and other costs (insurance, management and terminal fees).|
|Fair Market Value||The asset will depreciate over the asset’s useful life. The market will dictate the value in the future if there is desire to sell the asset.||The change in value for the asset has no effect on your financials; however, FMV does affect the cost associated with the next lease for comparable equipment.|
|Usage||You’re free to use the asset as much as you want. However, excessive utilization significantly reduces the asset’s value.||Most leases limit the usage. (You can negotiate a greater utilization rate.) You’ll have to pay charges for exceeding your allowed limits.|
|Normal Wear & Tear||The purchaser is allowed to use the asset as much as they desire; however, any excessive wear and tear decreases the Fair Market Value of the asset below the normal value range.||Most leases hold you responsible. You’ll have to pay extra charges for exceeding what is considered normal wear and tear.|
|Lease Expiration or Note Satisfaction||Once the note is paid off, the asset is no longer held as security and you now own the asset outright.||Operating leases are two to five years in duration and require the lessee to return the asset to the lessor. Capital leases allow for the lessee to exercise a purchase option and retain the asset.|
|Modifications to the Asset||In general, the asset is your property to change as you desire, however, sometimes the note may have a clause identifying boundaries for customization.||Leases rarely allow the lessee authority to customize without permission.|
Overall Costs between Leasing and Buying
In a short summary this is easy. If your goals are short term, leasing is financially superior. On the flip side, the longer term business endeavor definitely favors the buy option. The math bears this out. It makes sense. In the lease form, the asset is simply rented to the user. The lessor still retains title and therefore the long term benefit associated with the asset. When you own the asset and use it for an extended period of time or completely consume its utility, then the efficiency of the value is passed to you.
So let’s compare the actual costs for a real life asset that almost every business owner has to face. No, not an automobile, those are too easy. Let’s look at an office copier. Do we buy it, or lease the asset? Let’s find out which one is the better deal.
- Copier has a $9,000 price tag
- Copier has a life expectancy of 700,000 copies
- Copier has a 2 year warranty with the purchase
- Extended warranty lasts for three additional years or 500,000 copies (total) whichever comes first at a cost of $900
- Expected usage rate is 70,000 copies per year
Lease a Copier
The copier company uses a national leasing company that finances copier leases. The lessor will lease the copier for three years at a cost of $216.25 per month with an up-front fee of $423 plus the first month’s lease payment. The agreement is one payment for $639.25, 35 payments of $216.25 and a termination cost of $75. In addition the lease restricts the maximum use to 210,000 copies with an additional cost of 6.167 cents per copy in excess of the limit. Your total usage over the three years is 227,447 copies or an excess amount of 17,447 copies. The excess fee equals $1,075.96. The following is the total lease costs:
Up-Front Fee $639.25
35 Monthly Payments 7,568.75
Termination Fee 75.00
Excess Utility 1,075.96
Total Lease $9,358.96
Buy a Copier
Your bank has agreed to finance the copier with a note contingent on a 20% deposit. The note’s interest rate is 8.25% and is amortized over 48 months. During this period of time, your personal property tax on the unit is $43.18 the first year and it decreases by 10% per year. You agree to purchase the extended warranty for the $900 which is paid up front. Total Costs for the first three years is as follows:
Sales Tax (6%) 540.00
Extended Warranty 900.00
36 Payments to Bank 6,358.29
Property Taxes 117.02
Sub-Total for 3 Years $9,715.31
Balance of Bank Payments $2,119.43
Property Taxes 108.41
Major Repair in Year 6 1,497.22
Sub-Total for Four Years $3,725.06
Total for Seven Years $13,440.37
During the first three years, the lease is significantly less expensive than the purchase option. This is even with the stiff penalty associated with excessive use. Did you notice how the lease payments were more than the note payments? This is due to the high down payment requirement under the bank’s requirement. In addition, the leasing company held the risk associated with repairs while under the purchase agreement, the buyer opted to pay for the extended warranty. Notice that under the purchase option, the buyer pays no penalty for excessive use of the equipment.
In addition to the warranty, the purchase option required payment of property taxes directly to the local government. Under the lease, the lessor held that responsibility, although that cost was passed to the purchaser under the monthly lease payments. Many modern day leases actually require the lessee to pay the property taxes directly to the local government or pay them to the lessor who then pays the bill.
What should stand out to you is the significantly reduced cost of purchasing the asset as it relates to years four through seven. The primary driver of this reduced cost is complete ownership after year 4 thus no more monthly note installments. You now own the asset outright. There is a major repair cost in year six, notice how it occurs after the five year warranty expires (go figure).
Both options require the business to pay for toner and paper. Many copier dealers will sell a service agreement covering toner and regular cleaning maintenance. However, to keep this example simple, I left that business issue out.
The above financial comparison bears out the basic attributes of a lease option in comparison to the purchase option. Often the lease cash out is less than the purchase option during the early periods of time. However, as the time progression extends further out, the purchase option becomes less expensive. On the flip side of this is the utility aspect of the asset. As I will explain later in this article, sometimes the asset gets outdated and its production output value can diminish.
Advantages and Disadvantages
Each option carries with it certain advantages and disadvantages. I’ll first cover buying an asset and then leasing a similar asset.
The primary positive attribute associated with a purchase is the ability to retain the asset well into the future. You have full control over the asset and the final disposition. You may sell it and get some cash back or completely use up its utility. However, there are some drawbacks to a purchase. These include the following:
If a complete outright purchase, cash is used that could be used for other more lucrative purposes. These include working capital, seasonal buffer for operations, or just hold the cash and make your balance sheet look better (better current and quick ratios). So let’s start out this comparison by reviewing the positive attributes of a purchase.
- Full control over the asset
- Retention of the asset for extended utility
- Exercise Section 179 of the tax code and gain valuable tax reduction savings up front
- With title ownership, you may modify the asset for greater utility or to meet specific needs
Just as with any issue, there are negatives with the purchase option. These include:
- If financed, the interest rate is often slightly higher than lease rates due to bankruptcy issues from the perspective of the lender (lessor’s own the title and therefore bankruptcy by the lessee cannot prevent or delay asset retrieval)
- Any major breakdown expense or casualty exposure is borne by the buyer
- No gain with manufacturing improvements related to the asset whereas with a lease you may upgrade to the modern asset upon lease renewal
The fundamental foundation of a lease is the overall reduced cash outlay over the utility period of use. In effect, the primary advantage of a lease is less cash out of pocket. This is a significant advantage for any growing company. This allows for cash availability for other purposes. The following are lease advantages in order of value:
- Increased cash flow
- Obsolescence – if the asset becomes outdated quickly, a lease allows for the company to replace the asset in the future with more modern equipment. The best example of this relates to technology (computers, communications, software etc.).
- Easy disposal – at the end of the lease, turn the asset over to the financing company and walk away. Under the purchasing format, you may have to pay to dispose of the asset or pay costs to carry the asset on the books (storage, advertising, maintenance).
- Available financing – lessors provide easier and more accessible financing than purchase options. Remember, this is more of a rental situation than an ownership situation. So often the terms are much better for the lessee in comparison to traditional bank financing.
- Reduced maintenance costs exist because the asset belongs to the lessor. Any major breakdown is a risk shifted to the lessor.
The offset to all this relates to the disadvantages associated with leasing an asset. The nature of the deal is lack of ownership and retention of the asset upon final payment. Depending on the nature of your industry and the type of equipment, this may be detrimental and an expensive mistake. The following is a short list of disadvantages related to leases:
- Never favorable to the lessee, often the terms are onerous upon termination. Think of this from the lessor’s situation, do they really want to own the asset at the end of the day. They must either re-lease the asset or pay to get it sold. Worse, lessors often find themselves holding a worthless asset due to excessive wear and tear or plainly outdated equipment (think of technology based equipment). Some assets have a limited market and therefore very few opportunities to sell the asset(s).
- No tax advantage – contrary to popular belief, there is NO real tax advantage. I would actually argue that the purchase option has greater tax advantages associated with Section 179 of the Code or even accelerated deprecation under MACRS within the code. Historically, there existed tax advantages to leases. Most of these advantages related to comparing the tax savings on the lease cash outlay against straight line depreciation under the purchase option. In addition, the property tax was paid by the lessor. That was 25 to 30 years ago. Today, lessors are much more aggressive in passing these costs onto the lessee. Look at the lease, almost every lease now passes the cost of property taxes and the initial sales tax onto the lessee. Furthermore, Congressional authorization allowing for accelerated and special depreciation transferred the tax advantages to purchased assets.
- Business risk is borne by the lessee due to the nature of the industry for which the asset is producing revenue. If there is economic downturn or a change in demand associated with the asset’s production (e.g. nobody wants the widget produced by the machine anymore), then the asset will sit idle and the lessee is still responsible to make the payments.
- Misleading financial information is presented on the balance sheet. For some, this is considered an advantage, but for the small business operation, you are only kidding yourself. Since you are not publicly traded, you don’t report to other investors, most likely you and your family are the majority if not the only owners of the company. Therefore, any misinformation only misguides you in your decision process.
- No right to sell the asset as you do not own the asset, this is detrimental if there is sudden market increase in value associated with that asset.
From reading the above information, you should immediately key in on the asset’s purpose as the primary question in the decision model. If short term utility or if you need asset improvements (technology, communications, and/or safety) then your thoughts should be thinking lease. Long-term utility provides tremendous credence to the purchase option over leasing. So let’s begin the model with that primary question and go from there:
First Question: How long do I expect to use the asset?
Answer: If short period of time – lease has better overall return on the investment
If long-term is required – purchase has significantly better value especially the longer the utility of the asset.
Second Question: Is my business expanding at a high rate of growth i.e. at least 50% per year?
Answer: If yes, then there will be a great demand on cash and any cash savings in the fixed asset aspect of the balance sheet will better capitalize the growth. In effect, leases are a preferred tool for asset appropriations.
If growth is less than 10% per year, then cash can be used for asset purchases and the buyer should refer to the first question for guidance.
Third Question: Is the asset under consideration highly marketable like a vehicle, tractor, farm equipment, or office equipment?
Answer: If yes, then a purchase decision may be warranted due to the marketability of the asset. The easier it is to sell a used asset; the less concern for the buyer with the purchase option. However, the first two questions should take precedence over the marketability of the asset.
If no, then you open yourself up to utility risk for the particular asset. It is possible that the market for the purpose of the asset may change or is impacted by other elements making the asset less valuable or worse, worthless. Here, a lease shifts the risk to the lessor.
Fourth Question: Do I need to control the asset for production, modifications, relocation, or to trade at will?
Answer: If yes, the purchase option is the better choice, but weigh in with the first three questions prior to considering this issue.
If no, leasing the asset is a better option for you. However, the first three questions should provide better guidance in your final decision.
The above four questions should be weighed based on your industry and the asset itself. In my opinion, the first question has more value than the second, the second more credibility than the third and so on. Don’t based your decision on any one single question, weigh in with all of them and the best answer will prevail. Even after you make the final decision, there are still other issues for consideration that can sway or pretty much solidify the answer. These other issues include the terms related to the lease or note. The amount of the up-front payment or down payment has some bearing on the answer. I will write an article in the near future teaching you how to interpret a lease and how to negotiate a lease agreement.
Conclusion – Lease or Buy
From the above information, you as the business owner can understand that the lease or buy decision is based on several issues. There is no one outright correct answer. I have a tendency to prefer the purchase option mostly to have control and retain equity. The reality is that leasing/financing institutions are in it to make a profit; so be leery of a lease. You are in business to make a profit, don’t hand profit over to somebody else unless the decision model above warrants the lease. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.