My printing business is growing and I'm going to need some new equipment. Would I be better off leasing or buying?
Vacillating in Vermont
Dear Vacillating in Vermont,
The classic answer to your question is a resounding "that depends."
Leasing assets, rather than purchasing them, is a form of financing that avoids the large down payment frequently required for asset purchases, thereby freeing up funds for other business expenditures. Leasing companies, as well as banks, some suppliers and even manufacturers, will gleefully rent equipment to qualified small businesses.
On the other hand, since the proverbial free lunch is still non-existent, there is a cost associated with this form of alternative financing. In order to answer your question as to whether you'd be better off leasing or buying new equipment, you'll need to work through the relative costs and benefits of each choice. Here are a few points to consider.
The advantages of equipment leasing include:
- Frees up cash — Many leases require little or no down payment. Leasing thereby allows you to direct cash toward other business expenses and investments. An improved cash position can also help your ongoing ability to obtain additional debt.
- Shows less debt on your financial statements — In a straightforward operating lease, in which you rent assets for a set time period without an ownership interest, neither the leased asset nor the cost of leasing appears on a balance sheet. Cash flow and expense-related financial statements will show only lease amounts as they come due. The relative absence of business debt will improve your chances for conventional loans.
- Allows more flexibility for equipment changes and upgrades — For businesses in which rapid technology changes or new equipment is common, leasing allows you to minimize the costs of purchasing equipment that is quickly antiquated. Many leasing companies also provide for lease upgrade options or termination fees. In addition, an option to purchase a leased asset is usually available if you want to buy the asset at the end of the lease term.
- Is tax deductible — Leasing costs are deductible expenses that immediately reduce taxable income. You should compare the benefits of a lease deduction to the depreciation deduction you would obtain if you purchased the asset.
The disadvantages of equipment leasing include:
- Overall cost — The biggest disadvantage of leasing is that your costs over the life of the asset are generally going to be higher than if you purchased the asset. This is because your rental payments must compensate the lessor not only for acquisition and financing costs, but also for the lessor's retained risk of continuing ownership.
- No ownership interest — Your lease payments generally do not establish any equity in your leased equipment. In other words, at the end of the lease you won't have a tangible asset to show for your payments. This can be especially painful if you've grossly underestimated what the equipment would be worth at the end of the lease. Negotiating a purchase option under which a portion of your lease payments are credited to the purchase price is one way to effectively create equity in leased property.
- Lost tax benefits — Assuming that the IRS doesn't recharacterize your lease as a purchase for tax purposes, a potential disadvantage of leasing is losing the tax benefits of depreciation deductions that come with ownership. This disadvantage may be insignificant, however, if the "lost" benefits are offset by your ability to deduct your rental payments or if you have insufficient income or tax liability to be offset by the lost deductions and credits.
- Commitment to property — Once you sign a lease agreement, you're generally committed to making payments for the entire lease period even if you stop using the property. Most equipment leases are either non-cancelable or impose a stiff penalty for early termination.
The Toolkit has an extensive explanation and case example on the lease vs. buy decision, which you may find helpful to review in detail.
Because more businesses are using leases, greater creativity in lease terms and purposes are becoming available. Leases can be drafted so that they resemble a long-term purchase of capital equipment. The term of the lease approximates the expected useful life of the asset, and the total of lease payments is keyed to the underlying cost of the asset. The lessee pays insurance and taxes on the asset. The lessee may be required to purchase the asset at the end of the lease, or a purchase option may be available at the end of the lease or for a stated price during the term of the lease.
Also, be aware that, as your ownership options/rights are increased in a lease agreement, your financial statements may have to show the lease as an asset purchase, with an accompanying listing of the asset and a liability for the amount of the "loan." These changes may negatively affect your debt/equity ratios and your net income.
And for those readers who are considering real estate rather than equipment, take a peek at our Toolkit real estate link for more information.
Personally, I would always prefer to buy rather than lease, but sometimes that's a luxury that just can't be afforded. Leasing equipment or vehicles makes more sense than leasing real property since realty is the real wealth builder for small businesses. Consider the auto dealer on the edge of your town who eked out a living selling maybe a dozen vehicles a month for years, only to become a multi-millionaire after selling his 14 acres to Wal-Mart.
One final tip—whether you lease or buy, think long and hard before you sign and pay for a maintenance contract. You'll almost always be offered such a contract, and in general, they are almost never worth what you'll pay for them.