Advantages and disadvantages of leasing
A lease is a contract in which one party, called the lessor, provides an asset to another party, called the lessee, for use over a specified time period, called the term of the lease, against specified periodic payments.
Leasing is a type of financing and just like any other mode of financing has its advantages and disadvantages. The following are some generalized pros and cons of leasing. Each lease or buy decision must be made after thorough quantitative analysis.
Leasing is popular due to its following advantages:
- Low initial cash outflow: Instead of paying all of the cost of an asset upfront, the lessee pays the total cost over a number of periods, which reduces the drag on its cash flows in a particular period. Payments for the use of asset are due exactly when the asset is generating cash flows which makes it more manageable.
- Low risk of obsolescence: Leasing adequately guards the lessee against the risk of obsolescence, i.e. the risk that assets may lose their utility due to rapid changes in technology. A lessee can adjust the term of the lease such that it is no longer burdened with the asset when it is no longer efficient to operate.
- Off-balance sheet financing: For companies who are already high on debt, leasing provides a means of obtaining financing without worsening their debt ratio i.e. obtaining off-balance sheet financing. Even though due to change in accounting standards, most of the lease liabilities are brought on balance sheet, there are still some exceptions such for short-term leases, etc.
- Potentially lower finance cost: Since the lessor owns the asset during and after the lease term, the higher security normally results in lower cost of lease for the lessee than the financing cost it would pay in case of purchase of the same asset.
- Tax advantages: Since lease rentals in case of a leased asset are higher than the relevant depreciation expense in case the asset is owned, leasing can result in lower tax for lessee due to higher tax deductions (i.e. lease rentals).
- Flexibility: Leasing offers flexibility, for example a lessee might need an asset for six months and the asset’s useful life might be 5 years. In such a situation purchasing the asset might not be a practical option, while leasing may offer a term corresponding to the lessee’s requirement.
However, leasing is not without disadvantages some of which are as follows:
- Interest cost is not directly evident: Leasing has a rate of interest embedded in the required lease payments. For example, Company ABC has an option to purchase the car at invoice price of $50,000 or lease it out against 6 annual payments or $12,000. In short, the lease rentals do not only include contribution towards the use of asset, they also include a finance cost.
- Limited control over the asset and inflexibility in usage of the asset: In a leasing arrangement, the lessee does not own the asset during and after the lease term which means that he cannot sell or transfer or pledge it. However, some leases might include a clause entitling the lessee to purchase the asset at the end of the lease term against a payment.
- Any improvements made to the asset are lost at the end of lease term: The lessee is liable to bear the maintenance cost of the leased asset during the term of the lease even if he does not own it in the end.
by Obaidullah Jan, ACA, CFA and last modified on