All of us are familiar with what a lease is — a contractual arrangement between a lessor (owner of the property) and a lessee (renter of the property). It grants the right to use specific property for a period of time in return for cash payments.
Once an organization has decided to go the lease route (versus a purchase) when looking to procure capital equipment, it can encounter many lease options. As other departments and members of the organization, which could be engineering, R&D, and production, evaluate the technical aspects of the equipment, the supply professional and/or the business owner must identify the most advantageous lease method in accordance with the business’ fiscal needs.
There are five primary types of leases:
- Financial Lease
- Operating Lease
- Sale and Lease Back Lease
- Leveraged Leasing
- Direct Leasing
Financial Lease or Capital Lease
This type of lease is a long-term commitment by the organization using the equipment and cannot be canceled. Most of the risks that are incidental to the asset ownership, as well as all of the benefits, are transferred to the lessee even though the title to the goods stays with the lessor. However, the lessee has responsibility for maintenance, insurance, and repairs costs.
The lessee must record the lease as an asset on its income statement and record on its balance sheet current liabilities for those payments due to be paid in the next year and as long-term liabilities for payments to be made in the future.
The lessor must offer an option to the lessee to purchase the asset in use at the expiration of the lease.
The financial lease allows the lessor to recover 90 percent or greater of the fair value of the asset as lease rentals, and the lease period is 75 percent or greater of the economic life of the asset.
Financial leases may include the following:
- Full payout – the lessee pays the full purchase price, plus interest charges, maintenance, insurance, and administrative costs.
- Partial payout – the lessee gains credit for the residual value of the leased item after the lease period is completed, and the lessee pays the difference between the original purchase price and the resale value, plus interest charges.
- Lease/purchase – the lessee has the option to purchase the equipment at the end of the lease or at specific time intervals. The purchase price represents the residual value of the asset; this may be determined at the outset or based on market value at the time the asset is purchased.
Organizations often prefer to keep liabilities off their balance sheets since doing so impacts the organization’s ability to obtain needed funding. Also, the capital lease requires life-cycle costing inclusion. The organization is responsible for all maintenance costs over the life of the lease.
This type of lease provides the lessee only a limited right to use the asset. The lessor is responsible for the upkeep and maintenance of the asset. The operating lease is used for short-term needs and is revocable at a short notice. There is no interest in providing the lessee an opportunity for purchasing the equipment at the end of the lease.
Lease payments are noted as expenses on the firm’s income statement and as revenue for the lessor.
The lease term is equal to or less than 75 percent of the estimated economic life of the property. The present value of the minimum lease payments with an appropriate discount rate must be less than 90 percent of the fair value of the property at lease inception.
An operating lease is an excellent resource when there is a high rate of obsolescence such as with computers, hardware, trucks, and automobiles.
The lessor records a payment as revenue, and the lessee records it as an expense.
Organizations that want to show high asset turnover ratio would not want the equipment noted as an asset on their balance sheets. Asset turnover exhibits how well an organization is using its short-term and long-term assets to generate sales and is sign of how an organization is managing its assets.
Formula: Net Sales (Income Statement) ÷ Average Total Assets (Balance Sheet)
Sales and Lease Back
This type of lease falls under the financial lease umbrella. Under this lease format, the owner of the asset sells the asset to a second party, who in turn leases the same asset to the owner. The owner is able to gain a quick cash inflow and now is responsible for lease payments to the second party.
The equipment stays in place, and there is simply a paper transaction.
In this type of lease there are three parties involved in the transaction: the lessor, the lessee, and a third party. The lessor borrows part of the purchase price of the asset from the third party or lender. The asset is held as security against the loan. The lease payments made by the lessee go directly to the third party. Once the loan is fulfilled, all surplus monies go directly to the lessor. The lessor is also entitled to the depreciation allowance associated with the equipment. This lease is considered as a subgroup of capital leasing.
In this type of lease a firm acquires the right to use an asset directly from the manufacturer, finance company, independent lease company, or special purpose leasing company. Direct leasing falls under the capital leasing umbrella.
When supply professionals analyze the decision to lease or purchase new or used equipment, they need to consider all of the above leasing options as part of the process. The analysis should include tax burden, impact of liability notation on the balance sheet, life-cycle costing, depreciation opportunity, and lease payment factors.
Marilyn Gettinger is owner and principal of New Directions Consulting Group, which works with organizations on improving their supply chains through process streamlining and reengineering. New Directions Consulting Group offers workshops and consulting to companies from 30 employees to multinational corporations to upgrade purchasing, inventory, and supply chain processes. Gettinger, who earned her MBA from Fairleigh Dickinson University, teaches total quality management, supply chain management, and international trade at several post-secondary schools. She holds a C.P.M. and is a member of the Institute for Supply Management and the American Production and Inventory Control Society.