Relative advantages of capital vs operating leases

Leasing serves as a good alternative to traditional loan financing, offering benefits like lower upfront costs and greater flexibility. A lease is essentially a contract between two parties, and it involves a business or individual (the lessee) having a financial agreement with the owner of a particular asset (the lessor), enabling the lessee to use the asset for a specified period of time in exchange for regular payments.

Within the realm of leasing, operating leases and capital leases are the two primary options to choose from. This decision carries considerable weight for any given company's finances, underscoring the importance of understanding how each type will affect your business.

This blog delves into a comparison of both lease structures, exploring their advantages and disadvantages, so that you can make an informed choice.

What is an operating lease?

An operating lease is similar to a short-time rental agreement where the lessee periodically pays the lessor to utilise an asset. The lessor maintains ownership, and the lease payments are viewed as operating costs. Assets commonly leased under such agreements involve commercial vehicles and properties (like office spaces, retail outlets, and storage facilities).

Key elements of an operating lease

There are specific criteria associated with operating leases, such as:

• The lease duration is typically significantly shorter than the economic life of the leased asset.
• The lessee does not gain ownership of the asset when the lease term concludes.
• Lease payments are expensed as operating expenses on the lessee's income statement.
• The responsibility of repair and maintenance of the leased asset lies with the lessor.

What is a capital lease?

A capital lease is a long-term financial agreement where the lessee takes on the characteristics of an owner, along with the associated risks and rewards. Similar to taking a loan, the lessee pays the lessor at regular intervals over a specified timeframe, with the potential for asset ownership or acquisition as per predetermined terms. This form of lease is frequently employed for acquiring machinery and equipment.

What is a finance lease?

In today's accounting practices, the terms 'finance lease' and 'capital lease' are often considered interchangeable. Although there may have previously been finer differentiations (such as the fact a capital lease had to meet certain criteria like transferring ownership or offering a bargain buy option, while a finance lease was a broader category covering leases as financing), these disparities have diminished over time.

Key elements of a capital lease

The contract must follow at least one of the following criteria to be considered a capital lease.

• Provision for transferring title/ownership to the lessee.
• Bargain purchase option enabling the lessee to buy the asset at a predetermined time or materially reduced price compared to market value.
• Longer lease term covering a significant portion (more than 75%) of the asset's economic lifespan.
• Present value of lease payments surpasses 90% of the asset’s fair market value.
• Specialised asset with limited value to the lessor post-lease.

What is the difference between capital and operating leases?

The difference between operating and finance leases extends beyond ownership and duration. These differences are effectively summed up in the table below:

Operating vs capital lease: A comparison of advantages and disadvantages

The choice between an operating lease and a capital lease can significantly impact cash flow and the financial metrics measured by a company. By considering the advantages and disadvantages, businesses can gain insights to evaluate aspects like cash flow management, financial reporting implications, tax considerations, and the long-term commitments associated with each lease type. This will help them to determine which lease type best suits their financial objectives and operational requirements.

Advantages of operating leases

1. Lower initial costs

The initial costs required for operating leases are generally lower compared to capital leases and significantly less than the upfront costs required for purchasing assets.

2. Flexibility

Operating leases provide flexible lease durations and asset utilisation. Businesses can negotiate shorter terms, enabling them to upgrade to newer equipment more frequently, swiftly adapting to market changes. This flexibility supports regular equipment upgrades and adjustments to meet evolving operational needs.

3. Lower risks

Operating leases entail fewer risks compared to capital leases. Lessees are devoid of the risks associated with ownership such as asset depreciation or obsolescence. This is especially advantageous for businesses confronting rapid technological or equipment changes.

4. Cost savings

In operating leases, the responsibility for maintenance, repairs, and upkeep of the asset lies with the owner. This arrangement decreases associated costs, operational complexity, and downtime, especially for specialised equipment that necessitates regular servicing.

5. Off-balance sheet financing

Low-value operating leases offer a notable benefit in being potentially treated as off-balance sheet financing. This treatment results in the leased assets and related liabilities not being reflected on the company's balance sheet. This keeps the financial records of the company healthy and more appealing to investors and creditors, showcasing increased debt capacity, all while leveraging asset utilisation benefits.

6. Tax benefits

Being treated as operating expenses, lease payments may be tax-deductible for the lessee offering tax savings.

Advantages of capital leases

1. Ownership

A capital lease often offers the lessee with the opportunity to eventually own the asset without requiring a large upfront investment. It enables the business to build equity in the asset while fully utilising it during the lease term.

2. Tax savings

Finance leases are treated more like a purchase, enabling the lessee to claim tax benefits such as depreciation expense and interest expense deductions, thereby lowering their tax liabilities.

3. Control over asset

They grant the lessee greater control over the asset's use and management, offering flexibility and autonomy to effectively meet business needs.

4. Cash flow management

The long duration of capital leases allows businesses to spread the acquisition expenditure over a prolonged period, helping in better capital expenditure (CapEx) management. They typically offer fixed monthly payments, facilitating predictable cash flow, simplified budgeting, and enhanced cash flow management.

Disadvantages of operating leases

1. In operating leases, the lessee does not gain any equity in the asset.
2. The lessee has limited control over the leased asset, restricting modifications, subleasing, or other alterations to the asset.
3. In the long term, there is a possibility the cumulative payments made by the lessee will be more than the market value of the asset.
4. Off-balance sheet treatment of an operating lease may potentially alter key financial metrics and ratios, providing an incomplete view of the company's financial stability and performance.

Disadvantages of capital leases

1. Capital leases require complex accounting treatment and may involve additional costs such as interest, residual value, balloon payments, and disposal costs associated with the lease.
2. Capital leases are recorded as a liability, adding the risk of asset depreciation and obsolescence on the lessee. It can potentially elevate the debt-to-equity ratio impacting business's creditworthiness.
3. The responsibility for the asset's maintenance, insurance, and other ownership-related costs lies with the lessee, increasing the operational and administrative burdens for the business.

When to select capital vs. operating leases

Start-ups and businesses with limited funds may find operating leases favourable, as they provide access to expensive equipment without the burden of debt. Operating leases are ideal for temporary needs and in industries with rapid technological and market changes like IT, as they offer flexibility to adapt their assets according to changing needs without being tied to long-term commitments.

On the other hand, capital leases are advantageous for items with long-term utility and assets that retain their value over time. As the leased asset serves as collateral in a capital lease, businesses with limited credit history or lower credit scores may find it easier to acquire capital assets. Companies with stable cash flow may consider capital leases for their potential high returns and lower risk compared to other investments.

Organisations with a high debt-to-equity ratio (or those seeking loans or credit lines) often prefer operating leases to avoid increasing liabilities on their balance sheets, thus presenting more favourable financial statements. Conversely, businesses aiming to expand their asset base or leverage tax benefits may opt for capital leases.

Optimise your lease strategy with Financials

Operating leases and capital leases each come with their own pros and cons. Therefore, before making a decision, companies should thoroughly evaluate their financial health, business needs, objectives, and long-term plans. This evaluation should include various financial factors such as cash flow considerations, tax implications, and flexibility to determine which lease type best aligns to achieve the desired outcomes.

Having a financial management software like Financials can provide real-time insights and financial reports. This is essential to gain clarity on your financial health so that you can make optimal leasing decisions. Financials is an excellent tool for enabling financial analysis, budgeting, forecasting, and planning. With robust accounting functionality, Financials empowers finance teams to accurately manage all elements of their department’s obligations, including potential leasing data. Whether considering capital or operating leases, our financial management solution enables informed choices, efficient asset management, and transformative financial outcomes.