What’s The Difference Between Leasing And Financing?

November 24, 2022
Alok Suman
Lease Management

What are leasing and financing? Why should companies bother about leasing and financing an asset? Because in today's market, it could be particularly challenging for an individual or corporation to acquire a costly asset or equipment.

If a person or entity does not have the funds to pay for an asset outright, they may be able to utilize it by leasing or financing it. These are the two best options available in this scenario. 

But these two terms can be confusing at times. So here's a comprehensive guide that covers all the facets of leasing and financing, the key difference between lease and finance, and how leasing could be a better choice than financing. Let's begin.

What is Leasing?

Leasing is the term used to describe a contractual agreement that allows companies to utilize and manage an asset without actually having to own it.

In simple terms, a lease is an arrangement between the lessor who owns the asset and the lessee - the user of the asset.

In such an arrangement, the lessor pays for the asset on behalf of the lessee. The lessor then agrees to let the lessee utilize the asset in exchange for regular repayments. These are often called lease rentals or minimum lease payments (MLP). 

When it comes to claiming tax benefits or undertaking tax planning, leasing is advantageous to both parties involved. Thus, it is quickly becoming the most popular method of acquiring funds for assets.

Mostly, if there is no condition in the lease that requires the lessee to acquire the asset, then the asset is typically reverted to the lessor (the owner) at the end of the lease term. So after the lease agreement has expired, these are some potential options open to the lessee:

  • The lessee is responsible for renewing the lease, either permanently or for a set amount of time.
  • The lessee is responsible for returning the asset.
  • The asset is returned to the lessor, who then disposes of it by selling it to a third party.
  • The lessee purchases from the lessor.

Top Advantages of Leasing

Some of the key benefits of leasing include:

  • Eliminating Ownership and Associated Risks

One way to keep from putting money into an asset is to avoid taking ownership of it. It does so in a roundabout way, but it maintains low leverage.

As a result, the company maintains its access to prospects to borrow money. Plus, a lease serves as an off-balance sheet component.

  • Taxation Benefits

Both the lessor and the lessee are eligible to take advantage of the available tax benefits.

Since the lessor is the owner of the asset, the entity is eligible to deduct the cost of depreciation from its income while filing taxes. As a result, they get entitled to receive tax benefits.

On the other side, the lessee can deduct the MLPs, also known as lease rentals, from their income as an expense, hence achieving a comparable tax benefit.

  • Balanced Cash Outflow

The most notable advantage of leasing is that it allows the cash outflow or payments associated with leasing to be dispersed over multiple years, which relieves the strain of making considerable cash payments all at once.

This assists a company in keeping a consistent cash-flow profile over a tenure.

  • High-Quality Assets Become Affordable

When an asset gets leased, the lessor continues to retain ownership even while the lessee is responsible for paying all of the associated rental costs.

Because of this agreement, it is now feasible for a company to make investments in high-quality assets that would otherwise appear to be either costly or prohibitively expensive. 

  • Better Capital Allocation

If a firm opts to lease an asset rather than invest in it, it frees up the company's funds which it may then use to meet other capital requirements. It can also save up for more prominent decisions regarding capital investment.

What is Financing?

Financing refers to an agreement in which a financial institution provides the client with the funds necessary to purchase an asset.

It is a type of credit agreement where you are obligated to the entity that financed the asset, and as a result, you are required to repay the borrowed funds periodically.

Since it takes into account both the principal and the amount of interest owed on the borrowing, the cumulative value of the asset being financed is significantly greater than its cash value. 

When financing the asset, the first thing required is to make a down payment equal to a certain percentage of the asset's total value. Then, the remaining balance has to be paid off in equal portions over the course of the agreed-upon period. 

Companies or individuals can choose to postpone the repayments of the asset until a later period if they go with this choice. It means they will not be required to pay the complete sum all at once. They will finally be considered the legitimate owner of the asset once all of the monthly payments are made in full.

Top Advantages of Financing

The top benefits offered by financing include:

  • Preserving Current Credit Lines

Financing an asset/equipment lets companies concentrate their capital expenditures and lines of credit on the prospects and requirements of their core businesses while also offering to upgrade their equipment.

  • Enhanced Cash Flow Forecasting

Companies get in a better position for accurate cash flow projections when they finance assets since they are aware of the total fixed amount and the number of future payments necessary.

Additionally, it provides certainty because there are no potential concerns regarding rises in interest rates or future fees that may be subject to fluctuation.

  • Flexible Financing Options are Available

The financing of assets is now attainable at zero down payment and nil interest rate, where you ultimately repay the asset's cash value in installments.

This contrasts with the traditional practice of some lenders that require down payments and specific conditions for financing plans.

What is the Key Difference Between Lease and Finance?

When comparing leasing versus financing, it's important to keep in mind the following key distinctions:

  • Financing is making regular payments toward the purchase price of a product or service that is quite expensive. Autos, PCs, machines, and residences are typical examples of such assets. On the contrary, leasing is a form of borrowing whereby the lessee pays nothing up front, and the lessor takes ownership of the leased asset for a set period, typically a few years. The lessee has access to the commodity in question until the contract's termination date.
  • Rental payments in leasing are calculated as the cost to utilize the asset, while principal and applicable interest are paid over the life of a hire purchase agreement.
  • In the case of financing, one has to pay for the full cost of the asset. Hence, the monthly payment is substantially greater than in leasing. When you lease, you just have to pay for the time you actually utilize the equipment.
  • Once the buyer can do so financially, they are obligated to acquire the asset. When an asset gets leased, the lessee takes possession of it and pays rent to the lessor in exchange for the asset utilization during the lease term. After the lease term, the lessee gets the choice of purchasing the asset or not.
  • In the case of financing, the renter is liable for any necessary repairs and upkeep. Conversely, the lessee is responsible for it in the case of a financial lease, while the lessor would be responsible for it in an operating lease agreement.
  • If you get a loan or a lease, you can only utilize whatever you're financing for its intended purpose. At the end of a lease, the consumer can test out a different equipment or upgrade to a different version. For example, when a vehicle lease expires, the customer can upgrade to a newer model on the lease.

Leasing vs. Financing: Which One is Better?

In most cases, leasing is considered a better option than financing. Here's why:

  • Leasing doesn't necessitate any substantial down payments, whereas, in the case of financing arrangements, businesses should provide a down payment to lower their monthly payments.
  • While a financing arrangement obligates an entity to take ownership of the asset and thus pay for it in full, a leasing agreement provides them the flexibility to utilize the asset as long as they want it and there's no commitment to own it. 
  • Leasing does not require borrowers to provide security, while financing does require borrowers to pledge the current assets as primary or collateral security.
  • Compared to the monthly payment required to finance the identical equipment/asset outright, the cost of leasing typically results in significant monthly savings.
  • Leasing permits businesses to upgrade to more sophisticated equipment to deal with an increase in production volume without having to liquidate existing machines and purchase replacements. They don't get this liberty while financing the asset.
  • With leasing, companies can spread their payments over 10-15 years or longer. But in the case of financing, the repayment term is usually a lot shorter, around 3-5 years. 

Parting Thoughts

The borrower's financial situation and the anticipated value gained from the asset should influence the decision between financing versus leasing as a form of payment.

The primary distinction between these two options is the lower cost of the lease in comparison to that of the finance option. However, to arrive at a conclusion, one must first take into account a variety of factors and also bear in mind the perks and drawbacks of their options.

Businesses should ultimately select the alternative that is more in line with their financial resources and purchasing power. 

Check out LeasO, a cloud-based lease management software where you can track, manage, and centralize all your lease data in ONE place. With LeasO, you can organize and manage your leases while avoiding any manual accounting error.

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