When it comes time to invest in capital assets for their business, business owners are often posed with the question: do we finance the capital asset from our existing working capital? With a loan from the bank? Or through a Capital Lease?
In some cases, it may be easiest to finance capital purchases from cash in the business or through an operating line of credit with their bank. So long as the liquidity in the business is sufficient to do so, operating cash is often the cheapest and quickest means of capital. However, the banks do not like to see their operating lines used for capital purchases (they expect full revolvement year over year). To avoid disagreements with your bank, and to avoid tying up cash that could create shortfalls in working capital, it is often recommended to finance capital assets on their own.
Then it poses the question, do you finance equipment purchases with a loan from your bank or by way of a Capital Lease?
What Is a Capital Lease?
Before we outline the benefits of financing through a capital lease, it’s important that we understand what exactly a Capital Lease is and the difference between a Capital Lease and an Operating Lease.
An Operating Lease is the most common form of lease. No ownership transfer of the asset takes place and they are often short term in nature. The lessee never takes ownership of the asset, and instead “rents” the asset for an hourly/daily/monthly rate.
A common example would be renting a specific piece of equipment to do a specific job that is not part of your core business – a developer decides to pave their subdivision due to a scarcity of trades, but their core business is still building the homes. The developer and the lessor, in this case an equipment dealer, will agree on a daily/monthly rate, and they will pay the lessor that rate for the period that they use it. When they’re done with the equipment, they return it, pay for any outstanding parts of the lease, and move forward.
A Capital Lease is quite different. In many ways, a Capital Lease is very similar to a loan. You will often use a Capital Lease for equipment that is part of your core business, when you intend to purchase the equipment outright. A Capital Lease is different from a loan in that the lessor (in many cases the bank) technically owns the asset through the term of the Capital Lease, then transfers ownership of the asset to the lessee at the end of the term at a significantly reduced price – often $1 or 10% of the asset value. While the lessor technically owns the asset throughout the term of the Capital Lease, the lessee treats the asset as though they own it themselves. The asset is still recorded on their balance sheet as a capital asset and the capital lease is recorded as a liability.
Benefits of a Capital Lease
Higher Leverage: Since the bank technically owns the asset throughout the term of the lease, their security position is stronger as it is easier for them to liquidate the asset in default scenarios. This allows the bank to offer higher leverage against the asset. In fact, they will often finance up to 100% of the asset value by way of a capital lease.
Competitive Interest Rates: depending on the creditworthiness of the business requesting the lease, rates can be just as competitive as bank loans, and in some cases more competitive due to the tax advantages a bank gets from a lease
Depreciation/Amortization flexibility: Companies can increase the annual depreciation realized against the asset when it is an asset under capital lease, whereas companies must follow their local tax guidelines for depreciation when it is recorded as a loan and a normal asset owned by the business. This gives the customer flexibility when it comes to tax planning. As with any tax implicating decisions, it is advisable to speak to your accountant prior to purchasing any capital assets.
Increased Asset Variety: A wide range of assets can be financed by way of a Capital Lease. From software or shelving to excavators and trucks, there are few limitations as to what assets can be financed by way of a Capital Lease.
Heavy Competition: More and more banks, credit unions, and financing companies are entering the Capital Lease marketplace. This has increased the competition resulting in better rates and terms for lessees.
Quick and Easy Approvals: Approval and funding can be obtained in as little as 48 hours.
Limitations to a Capital Lease
Minimal Prepayment Privileges: as the terms of a Capital Lease can have an impact on both the lessor and lessees taxes, the prepayment privileges are often nullified with a Capital Lease. This can result in significant penalties in the event of prepayment. However, annual bullet payments or options to repay can be negotiated.
In summary, if you’re considering the purchase of capital assets, Capital Leases can be a very useful financing method. They enable you to keep your working capital available for your everyday business needs while still acquiring assets that will help your business grow. So long as you plan ahead to avoid any prepayment penalties, Capital Leases are a very flexible and affordable financing option for your business.