The traditional financing is related to the liability side of the balance sheet. The firm issues long-term debt or equity to meet its financing needs. and in the process, expands its capitalization. The dangers of traditional financing are that equity becomes an expensive method of financing because of decreasing corporate earnings and low price-earnings ratios. The high rate of inflation causes long-term debt which is an expensive source of financing as interest rates rise. The corporate finance managers, therefore, are developing financing alternatives related to the asset side of the balance sheet. These alternatives may lower the cost and redistribute the risk. Lease financing is one of the different alternatives.
Leasing is an important source of equipment financing. For some equipment, the financing is intermediate-term is nature. Leasing is broadly used in Western countries to finance investments. In the USA, which has the largest leasing industry in the world, lease financing contributes approximately one-third of total business investments. in the changing economic and financial environment of Bangladesh, it has assumed an important role.
Advantage and disadvantage of lease:
The advantage and disadvantages of leasing are summarised below.
Advantage of leasing:
Lease financing has the following advantage to the lessee:
Financing of Capital Goods:
Lease financing enables the lessee to avail of financing for huge investments in land, building, plant, machinery, heavy equipment, and so on, up to 100 percent, without requiring any immediate down payment. Thus, the lessee is able to commence his business virtually without making any initial investment (of course, he may have to invest a minimal sum for working capital needs).
Additional Sources of Finance:
Leasing facilities the acquisition of equipment, plant, and machinery without the necessary capital outlay and, thus, has a competitive advantage of mobilizing the scarce financial resources of a business enterprise. It amplifies the working capital position and prepares available internal accruals for business operations.
Leasing as a method of financing is less costly than other alternatives available.
Leasing provides finance without diluting the ownership or control of the promotion. As against it, other modes of long-term finance-for example, equity-normally dilute the ownership of the promoters.
Lease financing is considered preferable to institutional financing as in the former case there is no string attached. Lease financing is profitable since it is free from restrictive covenants and conditionalities, such as representation on the board, conversion of debt into equity, payment of dividends, and so on, which usually accompany institutional finance and term loans from banks.
Flexibility in structuring of Rentals:
Lease rentals can be structured to accommodate the cash flow situation of the lessee, making the payment of rentals convention to him. Lease rentals are so tailor-made that the lessee is capable to pay the rentals from the funds produced from operations. The lease period is also chosen so as to suit the lease’s capacity to pay rentals and consider the operating lifespan of the asset.
This flexibility is not available in the debt servicing pattern of a conventional loan; institutional borrowings, for instance. Such loans have to be typically repaid over a specified number of installments resulting in heavy debt servicing burden in the earlier years of the project, whereas the project may actually generate substantial cash flow in later years.
A lease finance arrangement is simple to negotiate and free from cumbersome procedures with faster and simple documentation. As against it, institutional finance and term loans require compliance of covenants, formalities, and the bulk of documentation, making procedural delays.
By proper structuring of lease rentals, a lot of tax benefits can be derived. If the lessee is in a tax-paying position, the rental may be increased to lower his taxable income. The cost of the asset is thus amortized more rapidly than in a case where the asset is owned by the lessee since depreciation is allowable at the prescribed rates. If the lessor is in a tax-paying position, the rentals may be lowered to pass on a part of the tax benefit to the lessee. Thus, rentals can be suitably adjusted for the postponement of taxes.
Obsolescence Risk is Averted:
In a lease arrangement, the lessor, being the owner, bears the risk of obsolescence and the lessee is always free to replace the asset with the latest technology.
To the Lessor:
A lessor has the following advantage:
The lessor’s security is fully secured since he is always the lord of the leased asset and can take repossession of the asset if the lessee fault. As against it, realizing an asset secured against a loan is more difficult and cumbersome.
Tex Benefit. The greatest advantage of the lessor is the relief by way of depreciation. If the lessor is in a high tax bracket, he can lease out assets with high depreciation rates and, thus, reduce his tax liability substantially. Besides, the rentals can be suitably structured to pass on some tax benefits to the assessee.
The leasing business is extremely beneficial since the rate of return is more than what the lessor pays on his borrowings. Also, the rate of return is more than in the case of lending finance right away.
Trading on Equity:
The lessor usually carries out his operations with greater financial leverage. That is, he has too much low equity capital and uses a substantial volume of borrowed funds and deposits. That is, he has an extremely low equity capital and uses a substantial volume of borrowed funds and deposits.
High growth potential:
The leasing industry has high growth potential. Lease financing enables the lessees to acquire equipment and machinery even during a period of depression since they do not have to invest any capital. Leasing, thus, keep up the economic growth even during a recessionary period.
Disadvantage of Leasing:
Lease financing suffers from certain limitations too:
Restriction on Use of Equipment:
A lease arrangement may impose certain restrictions on the use of the equipment, acquiring compulsory insurance, and so on. Besides, the lessee is not free to create additions or alterations to the leased asset to suit his necessity.
Limitations of Financial Lease:
A financial lease may entail a higher payout obligation if the equipment is not found to be useful and the lessee opts for premature termination of the lease agreement. Besides, the lessee is not named to the protection of express or implied warranties since he is not the proprietor of the asset.
Loss of Residual Value:
The lessee never becomes the master of the leased asset. Thus, he is deprived of the residual value of the asset and is not even named to any improvements done by the lessee or caused by inflation or otherwise, such as appreciation in the price of leasehold land.
Consequence of Default:
If the lessee defaults in complying with any terms and conditions of the lease contract. The lessor may terminate the lease and take over the possession of the leased asset. In the case of a finance lease, the lessee may be required to pay for damages and accelerated rental payments.
Understatement of Lessee’s Asset:
Since the leased asset does not form part of the lessee’s assets, there is an effective understatement of his assets, which may sometimes lead to gross underestimation of the lessee.
However, there is now an accounting exercise to disclose the leased assets by way of a footnote to the balance sheet.
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I like that you mentioned how lease financing is a less costly way of financing and allows a lessee to avail of major investments without engaging in immediate commitments. My best friend has been interested in starting an apartment complex business, but she wants to ensure that she would have the right tenants and lessees to manage the property and units. Maybe I should look for a management that offers assistance and residential leasing services in our area as she would probably benefit from that.