In August 2010, the Financial Accounting Standards Board issued a proposal that would require leases for equipment, corporate aircraft and real estate to be recognized on a lessee’s balance sheet. Although it is expected that the final standard won’t be released until later this year, it’s likely that companies’ financial performance metrics and ratios could be impacted. Nevertheless, the core benefits of leasing remain intact.
Proposed new accounting standards for operating leases could alter the way businesses obtain new equipment in the future. If that happens, chief financial officers (CFOs) will likely play a more active role in the negotiations between equipment dealers and purchasing managers because there could be significant financial reporting implications.
However, there are some inherent benefits to leasing versus purchasing that should remain unchanged regardless of the outcome of the ongoing debate. They include better cash management, reduced asset-value and obsolescence risk, reduced utilization and demand risk, and greater financing flexibility.
Possible Impact of Lease Accounting Changes
In August 2010, the Financial Accounting Standards Board (FASB) issued a proposal that would require leases for equipment, corporate aircraft and real estate to be recognized on a lessee’s balance sheet. Although it is expected that the final standard won’t be released until later this year, it’s likely that companies’ financial performance metrics and ratios could be impacted. Nevertheless, the core benefits of leasing remain intact.
In fact, many of those benefits apply to small- and mid-sized businesses as well as Fortune 500 companies, regardless of the type of product being considered. For some products, particularly information technology (IT) and office imaging, the benefits of leasing are well known. Most machines of this type become obsolete in short order; that’s why companies often time their leases to upgrade them on a regular basis. Less understood are the benefits of leasing other types of equipment in industries such as construction, transportation, food processing and general manufacturing. These industries have deeply ingrained cultures of ownership, but leases allow them to hedge a variety of risks.
Although each company’s situation is unique, this article will outline some of the most important reasons for leasing versus buying.
Improve Cash Management and Flexibility
Leasing can help businesses improve their cash management and create flexibility. Leasing frees up capital that would otherwise be tied up in a purchase while making payments predictable and affordable. Consider a few examples:
A golf course in the Northeast that is closed six months of the year uses a seasonal pay plan that defers equipment lease payments during the winter.
A call center chooses a three-year lease instead of purchasing IT and office equipment. The time value of money means that, instead of paying $1 million up front, the company will pay $850,000 over three years.
An automobile supplier that owns its equipment arranges a sale-leaseback that monetizes the equity in it and simultaneously frees up capital.
A construction company chooses an early buyout lease, preserving capital until more projects materialize and purchasing the equipment makes sense.
By working with lenders that are accustomed to dealing with equipment leasing, managers can obtain leases that are structured to maximize cash benefits and create financial flexibility. Structures to consider are:
Fair market value leases, which pass on tax benefits while the lessee retains no residual risk.
Sale-leasebacks, which monetize the equity in existing assets while the lessee retains usage of the equipment.
TRAC leases, which pass on the tax benefits, may include services to support fleet while the lessee retains some residual risk.
Mitigate Asset-Value Risks
In addition to cash management issues, leasing mitigates many types of asset-value risk. The advantages of leasing 20 out-of-the-box computers or a powerful new document management system are clear. After a three-year lease, the company can simply turn in those machines and upgrade the entire office — often without much change in monthly payments, given the steadily declining costs for these types of machines.
A second asset value risk connected to ownership is the cost of maintenance. Whether it’s a piece of food processing equipment, a plastic injection molding machine or a barge plying the Mississippi River, it will be prone to problems as it ages no matter the cost and size. For example, business owners should take into account the time-consuming process of patching old data servers. This can be costly not only in terms of repairs, but also in terms of business interruption. Leasing ensures that your equipment stays new, meaning you can reduce the amount of time and money spent on maintenance.
In addition to properly maintaining equipment, businesses that purchase equipment outright are responsible for ensuring that it complies with appropriate regulations. For example, upgrading to new equipment can alleviate the need to continuously retrofit vehicles to keep pace with evolving regulations. This can be extremely costly in terms of parts and labor, not to mention the threats to a company’s reputation in the event of an accidental breach.
Another responsibility associated with ownership is determining what to do with the used equipment. In most cases, you can’t just put it in the trash and few companies have the resources to accurately price, market and resell it. Electronics, including PCs and office imaging products, should be properly wiped of all proprietary data before a business disposes of them. Leasing the equipment enables business owners to return units at the end of the lease period and walk away hassle-free.
Manage Utilization Risk
Along with asset value risk, companies that own equipment must also consider utilization risk. Businesses often downsize, expand and move offices, so their equipment needs are always changing. One way to manage this is to match the term of the equipment lease to the term of the office lease.
In the construction industry, it’s common for contractors to take on projects requiring expensive and highly specialized equipment, but the cost of a month-to-month rental can be prohibitive. On the other hand, buying a new piece for a project that’s expected to last only two years seems inefficient if it won’t be needed after that initial period. Leasing allows a builder to match the use of specific equipment with a project’s end date — and then bundle that cost into its bid.
Diversify Financial Relationships
Finally, leasing is a way to diversify financial relationships. By expanding from local or regional banks to financing companies, businesses gain more than alternative sources of funding. They gain a trusted financial advisor and valuable ally that understands their business and can suggest additional scenarios that may offer improved capitalization strategies over the long term.
Before committing to any large purchases, executives should carefully consider the consequences of and alternatives to ownership. Many risks of ownership can seem far down the road at purchase. Leasing offers compelling cash management and risk benefits over ownership — advantages that are too often overlooked. However, before committing to a large purchase, executives should carefully consider the consequences, as well as the alternatives.
Jim Kelly is the chief commercial officer of GE Capital, Vendor Finance in Irving, TX. Vendor Finance operates more than 40 active programs, providing billions of dollars in financing annually to support equipment manufacturers and dealer networks. With long-term relationships and dedicated channel support, Vendor Finance works with small, medium and large enterprises as well as entities in the public finance arena. For more information, visit www.americas.gecapital.com.
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