Feature The pros and cons of leasing

Janine Mace examines the leasing versus purchasing issues directors should consider in the current market where access to finance remains tight.

In an environment where competition is tough and credit difficult to come by, companies are looking hard at every
dollar and actively trying to preserve capital wherever they can.

This means directors need to carefully weigh up the benefits of ownership against the flexibility of using some form of asset financing to fund new equipment and vehicles. The decisions don’t stop there, with the various GST, depreciation and balance-sheet implications for each financing product also needing consideration.

There are a number of financing options on offer, according to Joe Zappia, national chairman of the Mortgage and Finance Association of Australia’s equipment and commercial finance committee.

“In the small to medium-sized enterprise (SME) market, asset financing usually involves a chattel mortgage or commercial hire purchase agreement, while large corporate entities usually use finance or operating leases,” he says. “Selecting the right type of finance for the particular company requires specialist advice and expertise to work through the decision.”

Commonwealth Bank head of structured asset finance, Nick Fletcher, believes there are often more financing options available than directors realise. “People talk about leasing generically, but leasing is just one type of asset-based financing that is available,” he says.

Even within leasing contracts there are various options, particularly when the asset being financed is something larger than the average office photocopier. “Leasing facilities are not ‘one size fits all’ and boards need to recognise there is room to deliver tailored arrangements,” Fletcher says.

Mercedes-Benz national manager corporate sales, Brad Kelly, agrees that the decision to buy or finance – and the type of financing facility used – largely depends on the individual business. This is particularly the case when it comes to company vehicles.

“The decision comes down to personal circumstances such as tax considerations, the purposes for which the vehicle will be used and how long the company intends to keep the vehicle,” he says. “Every scenario needs to be reviewed in terms of the cost to the business. With leasing it is a known cost while with purchasing there are unknown costs and variables such as disposal costs.”

Certainty and financial discipline

For financing experts, certainty is one of the advantages of leasing.

“The real benefit of leasing is you have committed financing for the length of the asset’s usage,” Fletcher says.

“There are other benefits in terms of cash flow, commitment of the facility and in the broader risk-management category, the mitigation of residual risk as it removes the company’s exposure to obsolescence and moves in future market values.”

Kelly adds: “With leasing you know the cost up front, versus buying, where the costs are uncertain as the inputs and disposal costs are uncertain. Particularly if it is a fully maintained lease, then it is a more informed decision and you can match the costs to the cash flow in the business. It is more difficult to do this with the ownership model.

“Leasing is far more in tune with the concept of paying for something while you are using it.”

According to Kelly, a total cost of ownership (TCO) analysis needs to be undertaken by the organisation to effectively compare purchasing versus leasing. “A TCO analysis is very easy to do, but with the purchase model it is more complicated.”

Leasing also provides a useful overlay of financial discipline, adds Fletcher. “It is a form of debt, but it is structured and amortised over something like the life of the asset.”

It is also attractive to banks as it has an underlying security and is capital efficient for them. “There is a favourable view held by banks towards structured financing and that has clear benefits in this credit environment,” Fletcher says.

For companies, it also conserves precious capital and takes away the problem of disposing of obsolete assets.

“It preserves working capital, so 100 per cent of capital is available to the business,” says Zappia. “The disadvantage of purchasing is it has a big effect on cash flow and since the global financial crisis, cash is king. Plant and equipment needs to be amortised over time and leasing spreads the cost to match cash flow.”

Another major advantage of operating leases relates to the company’s accounts. While finance leases must be included in the balance sheet, operating leases are simply recorded as a note in the accounts, which can help improve a company’s debt ratios.

“With an operating lease it can be off-balance sheet, so it improves the company’s gearing ratios, which is not a feature of finance leasing,” Zappia says.

Drawbacks of financing

While the various forms of asset financing have many benefits, there are some drawbacks, particularly when it comes to financing smaller assets such as office equipment.

“There are terms and conditions on every lease agreement and they need to be carefully reviewed, including those relating to excess rates or conditions for usage, such as machinery hour use or extra mileage,” says Zappia.

“The equipment also needs to be returned in good working order, so if you have painted it, the colour needs to be changed back and all the parts need to be present when it is returned.”

The cost of returning the leased equipment to the lessor (which may involve inter-state transport) also needs to be considered, as does any termination fee for early repayment.

“Sometimes the business will want to retain the goods beyond the end of the lease, but there is no implied option to buy and this would have to be negotiated with the lessor based on the current market price,” Zappia adds.

Fletcher says these points reflect the fact that in the SME and mid-corporate market, lessors tend to operate with fairly standardised conditions. “But once you move into larger assets, lessors can be extremely flexible in their terms and conditions.”

In Kelly’s view, the only downside of leasing – particularly for company vehicles – is if the business intends to keep the asset at the end of the leasing period. “If the intention is to lease an asset that has a known life, there is no downside, especially with operational leases.”

End of operating leases

While asset financing has many advantages, upcoming regulatory changes may mean directors need to reassess the type of arrangement they select.

The International Accounting Standards Board (IASB) released the Exposure Draft for a new accounting standard on leasing in mid-August, which will force companies to put all operating leases on their balance sheets.

According to Grant Thornton national head of professional standards, Keith Reilly, boards will need to consider the effect of the new standard, particularly given the tight credit conditions and close scrutiny by banks of all corporate debt covenants.

“It could be viewed as the death of leasing as such. All operating leases will cease for businesses,” he says. “This will lead to changed gearing ratios and it will affect borrowing covenants, which will mean leasing will be less attractive for many entities.”

For some businesses, the change will bring new liabilities onto their balance sheets, which could see them failing to comply with existing debt agreements. “According to the IASB, with very few exceptions, leasing will now be on-balance sheet and companies will need to take up the liability regardless of the life span of the asset,” Reilly says.

While companies can explain to their bankers and market analysts that this is purely an accounting change that does not affect cash flow, Reilly believes the current nervousness around debt means directors will need to handle the situation carefully.

“Directors will also need to look at how they will handle existing leases if they are long term and also any new leases they are planning to take on,” he says.

What should boards ask?

When it comes to leasing, there are some key questions boards should ask senior management, according to Commonwealth Bank’s Nick Fletcher. These include:

• Do the lease conditions suit our company and its operational requirements? This includes conditions governing where, and in what condition, equipment is to be returned and usage limits. Leases that limit operational hours or charge high fees for excess usage may not be suitable if there are plans for a major expansion in production during the lease term.
  
• What Effect will the asset-financing arrangement have on the business’ other financing facilities?Directors should check how the contract will operate in conjunction with other corporate funding such as the core banking facilities and key debt covenants.
  
• What are the termination arrangements? The board needs to review what happens at the termination of the lease and whether (and at what cost) the lease can be extended.
  
• Is it value for money? Directors need to understand how the lease cost compares with the weighted average cost of capital and with the company’s core unsecured banking facilities.
  
• To what extent is the company exposed to various risks and how are they being mitigated? Leasing does not remove risks (for example, legal, occupational health and safety and accounting risks) and these still need to be identified and dealt with.