For most business startups, inadequate working capital to carry on routine business operations is usually a problem.
This may be a consequence of an insufficient startup capital to purchase and own all necessary assets. This problem could be solved by adopting the lease financing option.
What is leasing?
Leasing is a contractual agreement between the lessor (the owner a specified asset) and a lessee (the user of an asset) where the lessor conveys to the lessee, the right to the use of a specified tangible asset for a clearly defined period of time in return for a lease rental.
The lease period is mostly short term; between six and twelve months. However the lease period will depend on the offered and accepted lease term. The lease term is generally one of fixed, periodic and indefinite.
It’s important to note that the lessor retains the ownership of the leased asset. The lessee only has possession and use of the asset for a specified period as long as the rent is being paid.
Rental payments and other covenants must be clearly stated in the lease contract. Other binding covenants covered in the lease contract are:
- A provision that disallows modifications and alterations to the leased asset without the consent of the lessor,
2. The rental fee is stated, due date and a penalties for defaulting are clearly spelt out,
3. Conditions for giving warrantees and guarantees on the leased asset are specified and,
4. Any other terms and conditions as the lessor and the lessee may deem it necessary are captured in the lease contract.
A lease may be divided into two broad categories of operating or finance.
The operating lease is a short term cancellable contractual agreement which transfers the right to use an asset to a lessee but keeps the ownership risks with the owner of the asset.
The owner bears the costs for maintaining the leased asset and transfers this burden to the lessee as part of the rental fee. The lease period is usually less than the useful life of the leased asset.
A finance lease is a long term non-cancellable lease contract. A finance lease unlike the operating lease usually specifies a minimum payment plus an interest rate that is equal to or greater than the fair value of the leased asset.
It also offers a lease period that is more than eighty percent of the useful life and la purchase option.
Now, why is lease financing a good business financing option?
- Lease financing improves business profitability.
With lease financing, the value of total assets owned by a business is reduced and the reported earnings are increased. No depreciation expense on assets not owned by the business is deducted from the gross profit.
Therefore, the net profit is higher than what it would have been if such an expense was deducted.
2. Lease financing lowers high gearing effects on capital structure that is usually associated with debt financing.
A business which takes the option of lease financing jettisons the option of borrowing to finance purchase of assets. The benefit is a low debt to equity ratio.
3. The fixed rental fee and periodic payments protect a business that has chosen the lease financing option against adverse effects of inflation.
The lease covenant does not allow the lessor, to respond to increase in prices or costs by reviewing upward the rent before the expiration or cancellation of the contract.
4. A business which chooses lease financing is spared risks associated the ownership of assets. Such risks as underutilized capacity, obsolescence and others are mostly borne by the lessor.
5. Lease financing is a fast and convenient to get an asset for use.
A business in need of an asset for use in the short term can quickly and conveniently get it from a leasing company through the operating lease option. This makes sense than buying an asset that will only be used for few months.
6. Lease financing requires little money to get an asset for use.
As opposed to debt financing, where a significant compensating balance and collateral security are required, the ability to make an initial rental payment is enough.
7. Lease financing frees up a portion of the capital. The portion saved and not used for outright purchase of an asset, could be invested in marketing activities to boost sales and increase reported earnings.