An agreement between a customer and an asset owner, under which the customer leases the asset for a certain period of time, is known as lease financing. A sales lease or capital lease is a contract that requires recurring payments in exchange for receiving an asset from a company. Rental payments are referred to as lease rental, owners as lessors, and users as lessees.
Leasing examples
The following examples of financial leases can be found across a wide range of industries and require a large lump sum:
- Accommodations
- Vessels
- Engines that run on diesel
- Machines that are heavy
- Equipment used in plants
Lease Types and Financing
Lease financing can be classified into three categories: risk transfer, lease period, and number of parties involved.
- Leasing financing
- Lease agreement
- The sale and leaseback of properties
- Leveraged Leasing
- Finance Lease
In lease rentals, the lessor transfers all substantial risks and rewards associated with ownership of the assets to the lessee. When a lease lasts for a long time, it is usually not possible to cancel it before it expires. Leasing is divided into two phases: primary and secondary.
Lessors recover their initial investment through lease rentals during an indefinite period. During the secondary period, you will pay a lower lease rental rate if you opt for the peppercorn option.
Features of financing a lease
- Upon termination of the lease term, either in accordance with the main lease agreement or in a separate lease agreement, ownership of the property passes to the lessee.
- During the primary lease period, landlords charge a lease rental to cover their investment.
- The lessee is responsible for the maintenance and management of the asset.
- Lessors do not assume any asset-based risks or rewards.
Leases for operations
A lease allows the lessor to transfer ownership of an asset to the lessee without transferring ownership of the asset itself. Finance leases can’t be terminated, whereas operational leases can, so they’re a better option.
Operating a lease: features
- It is notable that the economic life of an asset differs from the lease term.
- If the lease is terminated with little notice, there will be no penalty for the lessee.
- The lessor faces risks and rewards as a lessor of an asset.
Leasebacks and sales
A financial leasing transaction involves the sale of an asset to another party, who leases it back to the seller for a specific amount. Sale and leasebacks are commonly used by sellers and lessees of real estate who are facing short-term liquidity crises.
Borrowing to leverage
Become increasingly popular is leveraged leasing, which involves a lessee, a lessor, and a lender. Typically, the lessee contributes equity towards the cost of the leased asset, and third-party lenders provide the remaining financing. These kinds of loans are commonly used to finance oil rigs, aircraft, and railroads.
Lease financing has many advantages
Investment-worthy
Lease agreements provide a higher rate of return than financing, which ensures a balanced cash flow and highly profitable business. Businesses maintain a steady cash flow profile by reducing one-time significant cash payments.
Assets of quality
The lessors retain ownership of the assets they lease to lessees. Businesses can benefit from this arrangement by investing in quality assets.
Income assurance
Once a lease agreement between a lessor and a lessee is signed, the lessor receives an assured and regular revenue within the specified timeframe.
Benefits of taxation
Due to their status as operating expenses, lessees include rent or lease payments in their profits.
Planning is crucial
Companies can plan expenses actively by keeping lease expenses constant over the asset’s life or increasing them in line with inflation.