Lease Financing – Meaning, Advantages and Disadvantages
Lease financing is a popular medium and long-term financing option in which the owner of an asset grant another person the right to use the asset in exchange for a periodic payment. The asset’s owner is known as the lessor, and the user is known as the lessee. A contract is to be made between the lessor and the lessee regarding the terms and conditions of the lease. After the lease period is over, the asset goes back to the lessor (the owner). There can also be a provision in the contract regarding compulsory buying of the asset by the lessee (the user) after the lease period is over.
The lessee is given the right to use the asset, but the lessor retains ownership, and the asset is returned to the lessor at the end of the lease contract, or the lessee is given the option to purchase the asset or renew the lease agreement.
A. To Lessor: The following are the benefits of lease financing from the perspective of the lessor:
- Regularly Assured Income: Lessors receive lease rentals by leasing an asset for the duration of the lease, which is a guaranteed and consistent source of income.
- Ownership Preservation: In a finance lease, the lessor transfers all risk and rewards associated with ownership to the lessee without transferring asset’s ownership, so the lessor retains ownership.
- Tax Advantage: Because the lessor owns the asset, the lessor receives a tax benefit in the form of depreciation on the leased asset.
- Profitability is high: Leasing is a highly profitable business because the rate of return on lease rentals is much higher than the interest paid on the asset’s financing.
- Growth Possibilities: There is a lot of room for growth here. Because leasing is one of the most cost-effective forms of financing, demand for it is steadily increasing. Even amid a depression, economic growth can be maintained. As a result, leasing has a much higher growth potential than other types of businesses.
B. To Lessee: The following are the benefits of lease financing from the perspective of the lessee:
- Capital Goods Utilization: A business will not have to spend a lot of money to acquire an asset, but it will have to pay small monthly or annual rentals to use it. The business can use its funds for other productive purpose.
- Tax Advantages: Lease payments can be deducted as a business expense, allowing a company to benefit from a tax advantage.
- Cheaper: Leasing is a form of financing that is less expensive than almost all other options.
- Technical Support: Regarding the leased asset, the lessee receives some form of technical support from the lessor.
- Friendly to Inflation: Leasing is inflation-friendly because the lessee is required to pay a fixed amount of rent each year, even if the asset’s cost rises.
- Ownership: After the primary period has expired, the lessor offers the lessee the opportunity to purchase the assets for a small fee.
A. To Lessor: The following are the disadvantages of lease financing from the perspective of the lessor:
- In the event of inflation, it is unprofitable: Every year, the lessee receives a fixed amount of lease rental, which they cannot increase even if the asset’s cost rises. So, it is unprofitable during inflation.
- Taxation twice: It is possible to be charged sales tax twice: The first is when the asset is purchased, and the second is when the asset is leased.
- Greater Risk of Asset Damage: As the ownership is not transferred, the lessee treats the asset carelessly, and there is a great chance that it will not be usable after the primary lease period ends.
B. To Lessee: The following are the disadvantages of lease financing from the perspective of the lessee:
- Compulsion: Finance leases are non-cancelable, and lessees must pay lease rentals even if they do not intend to use the asset.
- Ownership: Unless the lessee decides to purchase the asset at the end of the lease agreement, the lessee will not become the owner of the asset.
- Costly: Lease financing is more expensive than other types of financing because the lessee is responsible for both the lease rental and the expenses associated with asset ownership.
- Asset Understatement: As the lessee is not the owner of the asset, it cannot be included in the balance sheet, resulting in an understatement of the lessee’s asset.