Finance Lease VS Operating Lease: All you need to know

Finance Lease and Operating Lease both fall under the Asset Finance umbrella, which is a simple form of finance but one that has complicated terminology. Put simply, Asset Finance refers to the funding of assets or equipment, over an agreed period, in return for regular payments.

A Finance Lease and Operating Lease are forms of Asset Finance, whereby an asset is leased to a business over an agreed period, but both come with different terms and conditions, which could hinder or prove beneficial to your business.

So, let’s look at both types of asset finance and discover how they could work for your business

What is a Finance Lease?

A finance lease is a way of renting an asset over an agreed period from a leasing company, which purchases the asset for you. This form of asset finance puts the business leasing the asset (the lessee) in a similar position to if they had bought the asset, so all the risks and rewards that come with the asset sit with the lessee.

The leasing company that has purchased the asset retains ownership, but the lessee has exclusive use of the asset and pays the leasing bill to the lessor, not the manufacturer of the asset itself.

The lessee enters into an agreement whereby the original cost of the asset is covered by regular payments over an agreed period, and the full amount plus interest will be paid by the end of the contract, allowing the leasing company to have recovered all of its investment in the asset and the lessee will be able to either enter into a secondary finance lease contract, return the asset to the leasing company or sell the asset to a third party. Quite often title in the equipment can be arranged for the cost of a month’s payment

What is an Operating Lease?

An Operating Lease is also a way of renting an asset over an agreed period, however not all the risks and rewards of ownership sit with the lessee. The leasing period usually runs for less than the full economic life cycle of the asset and at the end of the contract, it would be expected that the asset has residual value, to allow the lessor to either re-hire it through another contract or more likely sell it to release that residual value.

The residual value is something that is forecast at the start of the lease and the risk lies with the lessor as to whether this value will be standing at the end of the contract. The lessee still gets full use of the asset in return for rental payments but the ownership remains with the lessor and the repayments don’t cover the full cost of the asset.

Finance Lease VS Operating Lease: Pros and Cons

You may be considering either of these forms of asset finance to help your business grow, so let’s take a snapshot look at the pros and cons of both types of finance.

Finance Lease Pros

  • No large sum of money needed upfront to acquire much needed assets
  • The leasing company purchases the asset on your behalf
  • All the rewards of ownership sit with you
  • Exclusive use of the asset as if it were owned
  • If entering a secondary rental period, payments tend to be much lower. Title can be arranged through a third party or sometimes directly through the lessor.

Finance Lease Cons

  • All the risks of ownership sit with you
  • Rental payments sometimes include a balloon payment at the end of the contract
  • Technically defined as non-cancellable but it may be possible to terminate the lease early

Operating Lease Pros

  • Not all the risks are transferred to the lesee
  • Lessee has full control over the operation of the asset
  • Other services are sometimes built into the contract, such as maintenance management
  • No large sum of money needed upfront to acquire much needed assets

Operating Lease Cons

  • Not all the rewards are transferred to the lessee
  • The contract usually runs for less than the full life span of the asset
  • The asset is expected to have a resale value at the end of the contract

Things to consider when choosing either Finance Lease or Operating Lease

One of the main takeaways from the table above is that with an Operating Lease, the risks and rewards of owning the asset remain with the leasing company, while with a Finance Lease, they are largely transferred to the lessee, this could be a deciding factor for most businesses in the current economic climate.

If an asset you acquire is likely to have a long and useful life within your business, then it may be that a finance lease is a better choice. The longer the asset is of use within your business, the less critical the residual value of the asset will become as it is likely to end up being a much smaller proportion of its original value.

If an asset is likely to have a shorter life span with your business, before an upgrade is needed, then an operating lease might be a better option. The shorter the use within the business the more chance the asset will have retained its value at the end of the agreement and as the leasing company is taking the risk when it comes to the asset’s residual value, this will be priced into the overall cost of the contract.

There is also a matter of how your company adheres to accounting standards. The International Financial Reporting Standards (IFRS) introduced IFRS16 on 1st January 2019 and brought about both operating and finance leases to be reflected in the company balance sheet and profit and loss account. Prior to this, an operating lease was treated as an off-balance sheet item. Most SMEs will be affected by this report, but for those that are not, the ability to fund assets, while keeping them off the balance sheet could be the deciding factor between the two.

How PMD can help you choose the right type of Asset Finance for your business

Finding the right type of lease for your business is essential in allowing you to grow and keep up with the competition. There are a myriad of rules and regulations when it comes to deciding on a finance lease or operating lease and the decision to enter into a long-term rental agreement can be a scary prospect.

At PMD, we pride ourselves in offering more than finance, advice and ideas are the lifeblood of our business and our experienced advisors are available to chat with you about the right type of lease for your business.

We have access to over 150 lenders and take care of all the hard work for you so you are free to focus on the running of your business and grow without limits.

Get in touch with PMD today to see how we can help you decide if a finance lease or operating lease is right for your business.

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