With such a wide scale of hardware and equipment on the market, it’s no surprise that leasing has become a normal affair in modern businesses. However, although it is a common practice, it isn’t farfetched to say its depth is broadly overlooked. Leasing isn’t a one size fits all asset solution. Instead, it is an umbrella term that covers other categories. With two, in particular, being heavily used by the businesses of today.

Finance leases are extensively used, and for good reason. They offer businesses an accessible means of addressing their asset and equipment needs, alongside a great deal of flexibility. However, finance leases do carry their risks. In this article, we will be discussing finance leases, how they work, and the associated risks.

What is a finance lease?

A finance lease is a type of lease wherein one party lends an asset to another, yet retains ownership over the asset. While the lessee gains operating control over the asset. This often goes by the alternate name of a capital lease. A finance lease usually bears a close similarity to equipment finance. Where a lessor either leases a previously owned asset, or finances the purchase of one, to a lessee.

Once the terms of the finance lease have been agreed upon and a contract signed, the lessee will have access to the relevant asset or assets. Legally, this is referred to as operating control. Meaning the lessee will be held responsible for the risks of operating the assets in question. They will also be required to record the asset, though the lessor will provide all the economic characteristics, making this an easy task.

How does a finance lease work?

Finance leases have several main points to be aware of to minimise risk. Though they are a bit more in-depth than the surface would imply, finance leases do follow the same general idea. We will break down a practical example later on, but for now, let’s take a look at what goes into a finance lease.

Economic life

Economic life is one of the most notable factors of a finance lease, as it will likely determine the effectiveness of the asset you rent. It refers to the length of time an asset is expected to remain useful to the owner. This does not mean the asset stops functioning, but instead that it loses its economic effectiveness. For example, although a biplane hasn’t lost its ability to fly, it became obsolete upon the invention of the monoplane.

When using a finance lease, you should be aware of the economic life of the asset. Usually, the lease will cover either the vast majority of an asset’s economic life, or the entire length. However, it’s good practice to have an idea of how long the asset will last.

Cost of maintenance

The lessee of a finance lease is typically responsible for the costs of an asset. This includes the costs of operation, in addition to the costs of any repairs or other maintenance. Before you enter into a finance lease, you should assess the state of the asset to ensure you aren’t taking on any undue risk. You will be out of pocket should those risks come to pass.

Cost of the lease

In addition to the upkeep costs of the asset, the lessee will be expected to pay a recurring fee to the lessor. These payments will, of course, begin as the lease does, and continue throughout the duration of the lease. Once the lease ends, you should have paid a similar amount to the fair market value (FMV) of the asset, as ownership of the asset should be transferred to the lessee in most cases. Before you sign any contracts, you should check the payments and the asset’s FMV to ensure you won’t be overpaying.

Record keeping

As mentioned previously, despite not being the official owner of the asset, the lessee will be expected to make records of the asset. This means that possession of the asset and any liabilities must be recorded as though the lessee was the owner, even though the asset is only in their possession temporarily.

A finance lease in practice

Although finance leases may seem to require a bit of legwork, they are quite simple in practice. At its barebones, a finance lease is little more than a standard commercial rental agreement. It starts with a business identifying the need for a piece of hardware, then distilling that need down to a specific asset. Once done, the business in question will approach the lessor, usually a company that specialises in such agreements, who will then make the purchase on their behalf.

After this purchase, the two parties will enter into a legally binding agreement, stating that the lessee will have operating control over the asset. Though the lessor will retain ownership for the duration of the lease. While the asset is operated by the lessee, it will be recorded as being in the ownership of the lessee, who will also be responsible for the operating costs and any maintenance or repair costs that are incurred.

As expected, the lessee will pay a recurring fee, usually monthly, for the duration of the agreement. This will amount to the fair market value of the asset. Plus a little extra in fees and interest paid to the lessor. Once the cost is covered and the money changes hands, ownership over the asset will be transferred to the lessee, concluding the agreement.

Although the above example is of a successful agreement, there are instances where the lessee is unable to make the monthly payments. In such instances, should there be no hope of repayment. The lessor will take possession of the asset and resell it. This is because a finance lease is usually secured against the asset or assets in question. To avoid this, it is crucial you do your research and buy within your means.

Should you use a finance lease?

Finance leases are a valuable tool in addressing a business’ hardware needs. They provide businesses with the means to obtain assets otherwise too expensive upfront or at too short a notice to work it into the budget. Although certainly a good option, finance leases are not without risk. Specifically, in the event you cannot meet the monthly payments, you are likely to lose the asset completely. This will, naturally, put you behind square one. As such, you should invest time into researching both assets and lessors, in order to minimise risks. If you can make the payments, a finance lease is a brilliant option.