One of the most significant decisions that challenge every small business owner is the decision to either lease a capital asset or to simply buy it outright. While there is no ‘one - size - fits - all’ solution, each business owner will have to consider various factors before coming to a conclusion. This article will highlight in broad terms, some of the factors that need to be considered.
Upfront Cash Outlay
Capital purchases require a significant amount of cash to purchase it outright or to use towards a down payment. Unless you have the cash available in your bank account, you may need to obtain a loan to facilitate the purchase of the capital equipment. With a lease, usually no upfront costs are required. A steady rental amount is paid over the lease term. This can help with cash flow management.
Tax Considerations
Lease payments are deductible for tax purposes. However you will not be allowed to claim any capital write-off or depreciation allowances. Owning a capital asset will entitle you to claim any capital asset write-off allowances based on the purchase price of the asset. The interest expense incurred on any borrowed money to finance the purchase will also be deductible.
Discounted Cash Flow Analysis
By using a discounted cash flow technique such as the Net Present Value (NPV) method, you can analyze the cost of the ‘lease vs buy’ problem by compiling a table of expected cash outflows and inflows related to the capital asset. Thereafter, using an appropriate interest rate, you will discount the cash flow amounts for each year.
Financial Statement Implications
Regardless of whether you lease or purchase the capital asset, the transaction will impact all components of the financial statements. Financial ratios such as the current ratio, asset turnover ratio and gearing ratio are just some of the financial indicators that could be impacted.
The income statement could see extra costs in the form of depreciation, interest, rent plus other incidental operating costs eating into your annual profits.
The cash flow statement will reflect cash outflows of amounts spent on capital assets and loan repayments. On the other hand, any cash inflows from loans received or assets sold will also have to be disclosed.
The notes to the financial statements may impose extra onerous reporting requirements. A few examples of what needs to be disclosed in the notes include: A reconciliation of the opening and closing balances for assets and liabilities; Accounting policies adopted; Security pledged for liabilities; Sensitivity analysis of rental or loan payments to changes in the interest rate.
The type of transaction will determine how much disclosure is required. The accounting rules for leases are governed by International Financial Reporting Standard 16 (IFRS 16). Lease accounting is very detailed and usually very onerous.
The accounting rules for asset purchases are governed by International Accounting Standard 16 (IAS 16). Accounting for a standard asset purchase is usually less complicated and has fewer onerous note disclosure requirements than accounting for a lease transaction.
How Long Do You Plan to Keep the Asset?
If you plan to use the asset for a short period, then leasing is a better option than buying and later re-selling. This could be beneficial with technology items that need regular updates or become obsolete sooner.
Reputation of the Lessor
Consider how long the lessor has been in the rental business; their financial stability; knowledge and expertise over their products. Does the dealer offer support if the leased asset does not work?
Risk and Rewards of Ownership
The responsibility for the operating costs, licensing, insurance, damages or losses need to be considered for both options.
Does ownership of the asset transfer to the lessee at the end of the lease term? If the lessee has a renewal clause, find out if you will get a newer, updated capital asset or if you will be stuck with the old one.
Security or collateral may be required by some lessors. Some lease agreements may impose a lease premium or contingent rental in addition to the normal rental that is specified in the lease agreement.
If you purchase the capital asset, you own it – You can sell it if you do not need it or you can use it as security for another loan.
Finally, do not forget about legal considerations as well as penalties for contract termination or misuse of the asset.
Contact CFO Nik Consulting Services Inc. to learn how you can perform your own lease vs buy analysis.
