Financial markets have grown and become more sophisticated, and that’s a good thing for companies looking to grow themselves. More options exist than ever for companies to expand in an increasingly competitive business world.
“One of those options is equipment leasing, which is becoming an increasingly popular way for businesses to achieve the growth they’re eyeing in an affordable way,” says Mark Heckler, group regional president of commercial services for MB Financial Bank.
Smart Business spoke with Heckler about what kinds of equipment leases are available to businesses and why they might be a better bet than conventional financing.
Why should companies consider leasing their equipment?
The growth and sophistication of financial markets has provided numerous capital sources to entrepreneurs to support the expansion of their businesses, and equipment leasing is one of those ways. The Equipment Leasing and Finance Association’s Web site indicates that in 2005, 27 percent of fixed business investment [excluding software] was financed via equipment leasing. This translates to $234 billion in 2005 alone.
What kinds of leases are there?
Leases can be classified as either a capital or operating lease. A capital lease is a type of lease classified and accounted for by a lessee as a purchase and by the lessor as a sale or financing, as long as it meets any one of the following criteria: the lessor transfers ownership to the lessee at the end of the lease term; the lease contains an option to purchase the equipment at a bargain price; the lease term is equal to 75 percent or more of the estimated economic life of the equipment; or the present value of minimum lease rental payments is equal to 90 percent or more of the fair market value of the leased equipment less related investment tax credits retained by the lessor.
An operating lease is generally defined as any lease that’s not a capital lease. One of the key characteristics of the capital lease is that the lessee may be entitled to the depreciation expense of the equipment financed. The other consideration is that under an operating lease, the lease payments are generally deductible for tax purposes whereas only a portion of the capital lease payments may be. As always, it’s wise to consult with outside professionals to determine the tax effects of any lease financing.
Another distinction is that a capital lease is a form of financing whereby the lessee will typically take ownership of the equipment at the end of the lease term. The lessee must determine at lease inception if the particular equipment will be required for the ongoing operation after the term. A good rule of thumb is that if the equipment will likely be replaced at the end of the lease, an operating lease may be an attractive option. Reasons for replacement may include changes in technology, changes in business processes or a perceived need to upgrade. Operating leases are generally suitable for IT, material handling, telecom and production equipment as these assets are frequently upgraded or replaced after several years of use.
How does leasing differ from conventional financing?
Compared to conventional financing, leases, particularly capital leases, may include 100 percent of the equipment costs, including installation and other attendant costs. For many growing businesses, the effective capital management can have a significant impact on the growth and success of a business.
For example, assume a business owner is contemplating a $50,000 piece of equipment used in her production process. Also, assume the owner can get a loan from her bank for $37,500 on the equipment, requiring her to invest $12,500 of cash for the purchase. If the effective annual rate of interest in a lease is 9 percent, the lessee must determine if she can use the $12,500 elsewhere in her business and earn an annual return greater than 9 percent.
What other sources can companies use to secure leases?
The growth of lease financing has created numerous leasing sources, which may include banks, leasing companies or the manufacturer of the equipment — either directly or indirectly via a lease program with a provider. These sources will have varying programs that will affect the amount financed, the payment terms, the requirements for maintenance, insurance, etc. The good news for entrepreneurs is the growth of this type of financing has created numerous alternatives that may be customized to the lessee’s situation.
In addition, if done properly, the comparison of lease and conventional financing programs will require business owners to evaluate their current situation, plan for the future and optimize their financing sources to achieve growth at the lowest possible cost.
MARK HECKLER is group regional president of commercial services for MB Financial Bank. Reach him at (847) 653-1820 or firstname.lastname@example.org.