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What is Leasing?
Leasing is a contract between two parties where one party (the lessor) provides an asset for usage to another party (the lessee) for a specified period of time, in return for a specified series of payments.
Leasing is an asset based financing structure that is built on the assumption that profits are generated by the lessee through the use of the asset rather than through ownership of the asset
This definition of leasing distinguishes legal ownership of an asset from its economic use.
Who are the parties in a lease?
A lessor is the owner of an asset that is leased under the leasing agreement and typically includes banks, independent leasing companies and captive lessors’ who are the manufacturers of the capital goods being leased.
A lessee is the entity leasing the capital goods from the lessor under the leasing agreement. He is the user of the capital goods and makes a payment or series of payments to the lessor in exchange for the use for a fixed period of time. A lessee can only be a company and NOT an individual.
What types of lease exist?
- A finance Lease (Also called Capital Lease): A finance lease apportions some of the risks and rewards associated with ownership to the lessee. Finance leases are not cancelable and the tenor is for a significant period of the Assets useful life. The finance lease envisages a full pay-out of both capital and cost of capital (Interest). This lease type allows for a post lease term acquisition consideration for the equipment to allow ownership be transferred from the lessor to the lessee at the end of the lease term. Under the finance lease, the lessee assumes the risks of maintenance, insurance and obsolescence and has the option to acquire legal ownership of the equipment at the end of the lease tenor.
- An Operating Lease: All risks associated with the ownership of the asset such as maintenance, insurance, residual value and obsolescence remain with the lessor at all times. An operating lease typically involves the lessee paying the rental for use of the equipment for a period of time which is less than economic useful life usually 81% of the equipment acquisition price. The lessor recovers his investment costs from a combination of the series of lease payments during the contract and the anticipated asset resale (residual) value from the equipment sale at the end of the lease contract.
What are the attributes of a lease?
A lease has the following main attributes:
- There has to be an agreement between the owner of the equipment ( the lessor) and the prospective or current user of the equipment (the lessee).
- The agreement gives the lessee the right to possess and use the equipment without necessarily owning it.
- The lessee pays the lessor for the use of the equipment usually by regular payments during the lease period.
After a predetermined period of use (the lease term), the lessee returns the equipment to the lessor or, depending on the lease arrangements, may decide to buy it, or continue to lease it for a secondary period, often at a lower fee.
What are the Advantages of Leasing?
Leasing is an adaptable form of financing and presents the following advantages to a lessee:
- Cashflow: Leasing eliminates the need for a business to commit capital to purchase equipment as a lease can be structured to cover 100% of the capital costs. Additionally, the periodic lease payments can be structured to meet the lessee’s business cashflow cycles.
- Tax: Leasing allows for the lessee to expense the lease payments with the accruing tax benefits.
- No additional collateral needed. Leasing unlike a traditional bank financing does not require the lessee to provide credit enhancement collateral as a secondary source of repayment for the capital goods.
- Predictability: Leasing affords the lessee a predictable financing environment in that the recurrent costs such as maintenance and insurance are incorporated into the agreed periodic lease installments.
- No risks of ownership: The lessee is freed from the risks of ownership particularly in terms of residual value and usage at the end of the useful life and also in terms of obsolescence.
- Easier to obtain: As a result of the flexible nature of leasing as a financing technique, it is easier and quicker to obtain than a bank financing facility owing to the higher risk tolerance characteristic of leasing.