The cheapest way of generating funds for capital investment is from retained profits but for many small businesses this may seem an impossible dream as pressures on profitability squeeze that source.
But one way in which they can get round the problem and obtain the modern equipment they need is through the facility known as leasing. Large companies have long been aware of the advantages of leasing but in recent years private businesses have also become familiar with this method of easing the strain on their resources.
When it leases assets, a business has the use of a piece of equipment immediately but pays for it out of its income. The payments are set against revenue for tax purposes and so help to reduce the company’s tax charge.
Existing credit arrangements are not affected and the firm’s gearing is not increased because a lease is not considered as borrowing, as would happen if the enterprise had taken on a loan to buy the asset.
Leasing will enable a business to calculate its cash flow more easily because payments have to be made at regular intervals and in known amounts. The leasing company cannot change the amounts – provided the firm pays on time – no matter how economic conditions change during the lease period.
Any business looking for certainty will find a fixed-term contract of this nature attractive, although for anyone who wants it, it is possible to negotiate a wide variety of terms in which rentals vary with such factors as tax changes or money costs.
One reason why a firm might want to negotiate different terms to a lease is that it may be in a business which experiences seasonal variations in cash flow, such as in tourism or farming-Payments can be tailored to fit in with this.
Leasing companies have devised a number of methods to meet different requirements, such as a plan where the amount of the instalment reduces as time passes, perhaps for such purposes as financing the purchase of a commercial truck on which more money has to be spent as it gets older.
Another version of this is the low start lease where instalments are low for the first three, six or nine months of the agreement. This could be useful where the machinery or equipment being installed may not come on stream or start paying for itself for a few weeks or months.
A feature of leasing is that the leasing company obtains the benefit of capital allowances on the equipment, which is reflected in the charges paid, but as well as the instalments being fully set against tax the lessee can reclaim VAT on the rental charges.
Another version of leasing is sometimes called lease purchase under which the firm does have the option to buy the equipment eventually. Under this scheme the firm can claim the full capital allowance itself, reclaim VAT on the purchase price, and set the interest payments against tax.
The reasons for opting for lease purchase rather than leasing itself depend to a large extent on tax implications. If a firm can make full use of the capital allowances available, lease purchase may be the right course, otherwise leasing may be the choice.
Leases usually run for three to five years, depending on the assets being bought – office equipment, for example, would usually be leased for the shorter period.
The theory is that decisions on replacing outdated machinery and equipment can be made more easily because there is no longer a temptation to hold on to a piece of equipment after its real economic life is over because of the impression that it then ‘costs nothing’ – though in fact there are facilities for low cost extensions to leases.
This does not necessarily mean that everything should be leased. Although payments are being made out of future income, so that real costs are falling over the period, payments are fixed and must be made on the due date.
A company should not commit itself too heavily to leasing any more than to other forms of finance; leasing must always be Part of a balanced mix of funding, while capital may not be tied UP in fixed assets, careful consideration has to be given to the uses for which equipment is intended and the income it is going to generate.
Costs vary considerably and it is advisable to shop around -remembering, of course, to get quotes which are on a comparable basis. One way of doing this is to ask for quotes of so many Pounds per £1000, thus giving a common base.
The different forms of lease available can be confusing – there is finance leasing, operating leasing, and sales aid leasing.
There is also contract hire, rental, hiring or plant hire, where the main difference is that leasing companies actually buy the equipment and lend it out from stock for specific periods.
In every case the leasing company retains ownership and the equipment only becomes the property of the firm leasing the equipment if it buys it at the end of the lease term.
With a finance lease the user makes payments over a period to cover the leasing firm’s capital outlay, borrowing costs and profit and the equipment is maintained by the firm using it.
Costs are not completely covered under some kinds of lease and the leasing company aims to recover the balance and make a profit by selling the asset or leasing it again once the first lease is completed.
These usually involve goods with a good second-hand market or where there may be rapid changes in technology and the equipment is not needed by a firm for all its working life.
With sales aid leasing there is usually a link between the leasing company and the manufacturer or seller of the goods, with the leasing package being offered as an alternative form of financing a deal or as a sales incentive.
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About the Author: Marie Mayle is a contributor to the MegaHowTo team, writer, and entrepreneur based in California USA. She holds a degree in Business Administration. She loves to write about business and finance issues and how to tackle them.