There are many advantages to leasing equipment over paying cash or bank financing.
Some people incorrectly view leasing as "last-resort" or expensive financing for start-ups. As evidenced by the number of financially sound companies who use leasing as an effective business tool; this is simply not the case.
The truth of the matter is that bank financing is often more expensive than lease financing (click to read why). Securing any type of funding for a start-up (loans, leases, etc.) compared to securing funding for an established firm typically requires a premium because there is more risk involved.
Before entering into a leasing agreement it is important to understand two things:
Working capital is a measure of solvency. It is the difference between current assets and current liabilities and is the net amount of working funds available in the short run.
Utilizing leasing as a procurement tool conserves cash and preserves working capital. How critical is it that your business remains strong and solvent? Preserve your most liquid asset.
Equipment leasing serves as a financing vehicle similar to a bank loan. However, depending on how a lease is structured, there are several key advantages to leasing over bank financing:
Not only does leasing offer advantages over bank financing, leasing offers advantages over paying cash for equipment.
It is a fact that revenues are created through the use of equipment; not through the ownership of equipment. Many successful business managers point out that it doesn’t make good business sense to use up cash for equipment purchases. They claim that paying cash for equipment is akin to paying several years worth of employee wages in advance. (Why pay for something upfront when you are not going to receive the full benefit until later?)
Spending cash on equipment significantly reduces Working Capital (Net Working Capital = Current Assets less Current Liabilities). Using cash for equipment purchases could potentially have an adverse effect on a company’s finances because less cash means the company is less liquid. Working capital is the “life-blood” of any business and is the most crucial component of a firm’s success.
Many business managers believe that using cash to purchase equipment is in fact more expensive than leasing. Take for example a new machine costing $100,000. Assuming the company is in the 40% tax bracket, a company must first earn $166,666 (pre-tax) in order to afford the purchase.
To lease that same piece of equipment, it might cost $2,240 per month (pre-tax) over the course of 48 months. Total pre-tax leasing payments therefore equal $107,520 spread over the course of 48 months compared with $166,666 upfront for cash purchase. “After tax” cost for cash purchase is $100,000 while “after tax” cost of the lease spread out over the 4-year term is only $64,512.
By now you might be asking “What should my company do with all the cash we were able to keep in Working Capital by leasing our equipment instead of outright purchasing?” Working Capital should be preserved for meeting the operational needs of the business. Utilize your cash for such discounts for monthly inventory purchases, parts purchases and raw materials purchases.
Let’s suppose that you (1) preserve cash as Working Capital to pay for these types of purchases (and do not have to borrow from a Bank line of credit because you didn’t tie your cash up in equipment) and (2) that you are able to negotiate a 1½% discount for prompt payment of each invoice: The result would be that you end up earning 18% per year on your Working Capital simply by discounting invoices. At the same time, you would eliminate the bank fees that you are charged when you draw down on your line of credit (because the line of credit is no longer needed.)
So you’ve decided to consider leasing your next equipment acquisition. What next?
Pricing is important. But remember, it is only part of the equation and therefore a portion of the overall value equation.
Here are some things that we recommend you consider when choosing a leasing option and leasing partner:
In other words, what happens at the beginning, middle and end of the lease? Does your firm automatically own the equipment? Is there a buyout? Is the buyout defined? If the lease is “open-ended,” what are your options at the end of the lease term? What happens if you don’t exercise any options? Does this put you in a situation where you could have more obligations that don’t make the best business sense?
Business is about relationships. Do you really want to have a relationship with the leasing company you are talking to? Remember that when you enter into a lease, you are hiring the leasing company for at least the duration of the lease.
Will they be a good hire? Do you know who you are hiring? Why did you choose the leasing partner that you did?
There are many reputable leasing and finance companies out there. Make sure you find one. We recommend that, at the very least, the leasing partner that you choose to work with is a member of the Equipment Leasing and Finance Association (ELFA)