Difference Between Finance Lease Vs Operating Lease

Lease is the most common concept in business regardless of which sector your company belongs to. It is a financial agreement in which the owner of the property, known as the lessor, agrees to rent it to you (the lessee). A legal contract standardises the lease terms and agreement, protecting the interests of all parties involved. The two most common types of lease financing are: finance and operating. In this article, we will learn not just the meaning of these lease agreements but their differences as well.
 

What is a Finance Lease?

 
Finance leasing, also known as capital leasing, is a contract that allows you to use a specific asset for a predetermined period. Under financial leasing, the lessor retains the asset title, and only the risk and reward are transferred to you as the lessee.
 
Once the agreement reaches expiry, the ownership is retransferred to the lessor. Financial leasing allows you to purchase the asset in question for a lower price than its fair market value. It further allows you to claim a tax deduction for interest payments and depreciation. However, this type of lease usually cannot be cancelled before the expiry date. 
 

How does Financial Lease work?

Assume you have started a manufacturing plant and need large plants and machinery for your operation. Since buying these machineries and plants can be a huge cost to bear in the initial stages of the business, you can get them on the lease for 40 years. 
 
Given the length of the agreement, you may have paid nearly all of the initial purchase price of the asset. And, because plant and machinery depreciate over time, the lessor gives you the option to purchase the capital asset at a nominal cost.
 

Features of Financial Lease

 

• Bargain power

  The lessee has the option to purchase the asset at a nominal value that is significantly less than the asset's fair market value.
   

• Tenure

  The holding tenure in a financial lease is typically greater than 75% of the asset's shelf life.
   

• Present value

  By the end of the lease, the lessee has typically paid 90% of the asset's original cost.

Also Read: Mistakes That First-Time Small Business Loan Recipients Make
 

What is an Operating Lease?

 
The operating lease is flexible in nature, allowing the lessee to cancel the contract before the due date. The lessor allows the lessee to use the asset in exchange for rent for a period much shorter than the asset's shelf life under this contract. In contrast to financial leasing, the asset owner does not transfer ownership rights to you under operational leasing.
 

How does Operating Lease work?

 
Suppose you own a restaurant in an area where there will remain a major power outage for a few months. Because you are unable to supply power for the refrigerator and other necessary appliances, any leftover ingredients or other perishable raw materials quickly deteriorate.
 
To deal with this, you intend to install a generator, but due to its high cost, you abandon the idea and instead intend to lease the generator and pay rent for it. The lease expenses are recorded in the profit and loss statement.
 

Advantages of Operating Lease

 

• No ownership

  Since you do not have an ownership right, you won't have to be worried about the repairs or maintenance costs. You can use the assets as and when you need, without bearing the ownership.
   

• Cost-effective

  Installation of costly equipment may not be feasible if you have recently started your business. Operating leases are beneficial in this situation because you only have to pay a small rent and then return the asset. It is one of the best ways to improve cash flow and lower operating costs. 
   

Disadvantages of Operating Lease

 

• No equity

  You don't have equity in the leased asset, and in the event of a financial emergency, you don't have any right to sell it. 
   

• Higher costs

  If you lease an asset for an extended period, you are likely to pay more than the asset's fair market value.
   

Also Read: Financial Tips To Set Up A New Business
 

Operating Lease vs Financial Lease: Key Differences

 

Parameters	Financial Lease	Operational Lease
Type of contract	It acts as a loan agreement.	It acts as a rent agreement.
Tenure	Long term	Short term
Transferability	Ownership right is transferred to the lessee, with the lessor retaining the title.	Ownership is not transferred.
Revocation	Cancellation is not permitted once the contracting parties have entered into the financial lease agreement.	Contract revocation on legitimate grounds is possible during the first few months.
Tax benefits	You can claim tax benefits on depreciation, financing charges, and any other amount spent on the asset's repairs and maintenance.	Tax benefits are available for rent you paid to use the asset.
Option	At the end of the lease contract, the lessor provides you with an option to buy the underlying asset at a much lower price than fair market value.	There will be no purchase offer made to you.
Obsolescence risk	It lies with the lessee.	It lies with the lessor.
Maintenance	The lessee is responsible to take care of the maintenance of the underlying asset.	Maintenance lies in the hands of the lessor.
Accounting	It is recorded in the assets and liabilities of the balance sheet.	It is recorded in the profit and loss statement of your business.

 

What are the alternatives to leasing?

 
Businesses usually opt for a lease, either if they are facing a cash crunch and cannot make an outright purchase of an asset, or if they need a particular asset for a short period. If you face the former challenge, instead of leasing, consider a business loan. A business loan is a financing product tailored to your specific need. If you want to invest in a capital asset, you can choose an equipment financing loan with a longer repayment period and a larger loan amount. A term business loan may be an option for equipment that does not require a large investment.
 
Also Read: Have you tried these 11 ways to improve cash flow in your business
 

Conclusion

 
The primary distinction between a finance lease and an operating lease is one of tenure. The former is a long-term agreement. Moreover, under financial risk, the lessor transfers the ownership right, which is not the case with the operating lease. Simply put, if you need an asset for a long time and believe that the financing cost will not exceed the asset's market value, a financial lease is a way to go. Otherwise, you always have access to a low-interest business loan.