A Comprehensive Guide to Operating Leases

Is an operating lease right for your business?

Operating leases can be a valuable financial tool for businesses wanting to acquire essential equipment without the substantial upfront costs associated with outright purchase.

The allure of this loan structure is in the potential advantages of maintaining agility and flexibility within financial operations. However, like any financial arrangement, operating leases have their downsides, and they may not always be the optimal choice for every business.

In this article, we aim to help you understand the intricacies of operating leases and how they can be leveraged effectively in line with your operational and strategic objectives.

Let’s dive in.

What is an operating lease?

An operating lease is a financial arrangement in which a business can use and benefit from a piece of equipment without owning it outright. In simpler terms, it’s like a long-term rental agreement for equipment, allowing the lessee (the business) to utilise the equipment for a set period while making regular payments, typically monthly. Unlike a capital lease, the operating lease does not usually result in ownership of the equipment at the end of the lease term.

How does an operating lease work?

An operating lease functions by allowing a business to benefit from the use of equipment without the burden of ownership. Here’s how it typically works:

Lease Agreement:

The lessor and lessee enter into a lease agreement specifying the terms and conditions, including the lease duration, monthly payment amounts, maintenance responsibilities, and any purchase options at the end of the lease term.

Usage and Payments:

The lessee uses the equipment for the agreed lease period, making regular monthly payments to the lessor. These payments are typically lower than what would be required for purchasing the equipment outright, making it an attractive option for businesses.

Maintenance and Servicing:

The lessor often retains responsibility for maintenance, repairs, and servicing of the equipment during the lease term, relieving the lessee of these operational costs and hassles.

Ownership Options:

At the end of the lease term, the lessee usually has several options:

Purchase: Acquire the equipment at its fair market value or a predetermined purchase price.
Lease Extension: Extend the lease for a further period if needed.
Equipment Return: Return the equipment to the lessor.

Payment Structure

The lease payments in an operating lease are based on the depreciation of the equipment during the lease term, adding to your affordability and making it easier to manage cash flow.

What’s the difference between an operating lease and a finance lease?

With an operating lease, it’s like renting a piece of equipment for a specific period. The ownership remains with the leasing company, and at the end of the lease, you typically have the option to return the equipment, extend the lease, or purchase it at its fair market value.

In a finance lease, you’re essentially purchasing the equipment over time through lease payments. Although you don’t own the equipment during the lease, you’re considered the economic owner and usually have a purchase option at the end of the lease for a nominal amount.

Types of Operating Leases

There are different types of operating leases that businesses can consider based on their needs and financial situation:

a. Fair Market Value Lease

In a Fair Market Value Lease, you have the option to purchase the equipment at its fair market value at the end of the lease term. This type of lease provides flexibility and is attractive for businesses where the technology or value of the equipment may change rapidly, such as in industries like IT, medical equipment, or manufacturing where advancements are frequent, and equipment can become outdated relatively quickly.

b. Fixed Purchase Option Lease

A Fixed Purchase Option Lease allows you to purchase the equipment at a predetermined price at the end of the lease term. This option provides clarity on the acquisition cost, making it easier for your business to plan for the future.

c. Percentage of Use Lease

In a Percentage of Use Lease, the lease payments are based on the actual usage of the equipment. This type of lease is particularly useful for equipment that may not have consistent or predictable usage throughout the lease term, such as in industries like transportation, agriculture, or construction, where equipment usage can vary based on project demands and seasonal factors.

What are the advantages of an operating lease?

Operating leases offer several advantages that make them an attractive financing option for businesses seeking to acquire equipment.

1. Cost-Effective

Operating leases are cost-effective compared to purchasing equipment outright. They typically entail lower upfront costs and monthly payments, making it easier for businesses to manage their cash flow. This financial advantage is especially beneficial for businesses with budget constraints or those looking to allocate capital to other critical areas of operations.

2. Flexibility

One of the significant advantages of operating leases is the flexibility they provide. Businesses can stay current with evolving technologies and industry advancements by easily upgrading or replacing equipment at the end of the lease term. This adaptability ensures that the business can maintain a competitive edge without being tied to outdated or obsolete equipment.

3. Off-Balance Sheet Financing

Operating leases offer off-balance sheet financing, which means that the leased assets and associated liabilities are not recorded on the company’s balance sheet. This accounting treatment can enhance your company’s financial ratios and metrics, providing a more favourable image to investors, creditors, and stakeholders. Additionally, off-balance sheet financing may help businesses maintain compliance with debt contracts.

4. Tax Benefits

Operating leases often come with potential tax advantages. Lease payments are typically considered operating expenses and are, therefore, tax-deductible, reducing the overall tax liability for the business. This tax treatment can result in significant cost savings over the lease term, enhancing the financial attractiveness of operating leases.

What are the disadvantages of an operating lease?

While operating leases offer flexibility and cost advantages, they also come with certain drawbacks that businesses need to consider when evaluating this financing option.

1. Long-Term Cost

One notable disadvantage of an operating lease is that the total cost over the lease term may end up being higher compared to purchasing the equipment outright. Although the monthly lease payments are usually lower and more manageable, when summed up over the entire lease period, they can surpass the cost of purchasing the equipment upfront. In the long run, this could represent a higher financial outlay for the business.

2. No Ownership Rights

Unlike a finance lease or outright purchase, an operating lease does not grant you ownership rights. While at the end of the lease term, you typically will have the choice to purchase the equipment at fair market value or return it to the lessor, during the lease period, you won’t have been building equity in the equipment. This lack of ownership can be a drawback for businesses looking to build assets or use the equipment for an extended period without additional costs.

It’s essential to carefully consider the specific needs of the business and conduct a thorough cost-benefit analysis before opting for an operating lease.

Looking for help with your equipment finance?

Working with a finance broker for your equipment finance needs not only saves valuable time but also ensures you have access to competitive lender prices.

At Southshore Finance, we help Perth businesses grow their business with a range of personalised business finance services, including an extensive network of major lenders. Being one of Perth’s most established commercial finance brokers, our experienced team is dedicated to ensuring you secure the right equipment loan with the best terms for your business.