Buy Vs. LeasPosted on Tuesday, March 1st, 2005 by Self Employed Web Team
When it comes to your company’s equipment—from cars to computers—which strategy is smarter? Both have advantages. The answer depends on your business and its needs.
All business owners face that inevitable day of needing capital equipment. Whether a manufacturing tool, a copier, a computer or a company car, you can bet it will be costly.
When looking for financing, you’ll face choosing between a lease and a purchase loan. Owners must weigh obsolescence, cost of money, taxes and cash flow to determine the best fit for the checkbook—and the business strategy.
With either lease or purchase financing, you pay interest for the entire cost of the equipment. The major difference between the two is that lease payments cover only part of the principle, so they are lower and you can walk away at the end of the term. But in doing so, you lose the remaining financial value of that asset. That’s why obsolescence is important. If the effective lifetime is over after a few years—for example, a PC that may not be compatible with new software—then a lease might make more sense.
Notice that word, effective. Sometimes equipment may continue to have value, but not enough to keep around. “Certain things become obsolete anyway,” says Stephen Losh, a partner in Beverly Hills Law Associates, which leases two late-model automobiles. “Unless you’re into repairing cars, your time is worth more than that.” If equipment will become increasingly unreliable, avoiding lost productivity might more than offset dealing with problems.
At the other end of the spectrum are types of manufacturing equipment that may have a lifespan of a decade or longer. By leasing, you have paid all the interest you would have paid under a similar loan, but you have to make an additional buy-out payment for the balance of the principle. And leases usually have higher interest rates than purchase loans, so you end up paying more for the equipment.
But comparing the money paid in each case is incomplete. You have to consider the impact on taxes and deductible expenses. “You may be able to buy a piece of equipment and deduct the cost of it all at once, up front, or over a period of years,” says small business tax professional Joseph Anthony of Portland, Ore. The right purchase structure can shift a deduction to a year when it’s needed most.
Even so, there are times when leasing ends up being the bigger tax advantage. There are restrictions on how much of an item’s cost a business can deduct. If the purchase financing costs exceed legal deductible limits—think of a luxury automobile—a lease still remains completely deductible and might actually reduce taxes to a greater extent.
Dollars and Sense
Sometimes the biggest consideration is cash flow. In general, leasing requires less cash outlay than a purchase, both at the onset and each month. If there isn’t enough cash for the equipment down payment or the monthly payment, then the decision is easy. Things get more complex when there is cash, but there may be better places to put it.
“The [question] is where you need to devote capital,” says Tom Winmill, president of New York-based insurance claims processing company Bexil Corporation. If a business can get a high enough return on cash, like investing in expansion and increasing revenues, then taking a lease to free up money may also make sense. “If you’re in a high-growth mode and need all the capital you can get, you lease. Low growth, buy,” Winmill adds.
Remember, too, that some digging might turn up more than one company that could offer a lease. That gives you a chance to shop for the best deal, although comparing lease terms is difficult, says Michael Randall, president of ParaLease LLC, a Miami-based company that writes software for the leasing industry. The combination of terms—including length of the lease, down payment and buy-out payment—can make direct comparisons tricky. To determine the best deal among various leases, you must determine the yield, or effective interest rate, using specially written software or a scientific calculator.
Aside from the strategic considerations, there are additional tactical rules of thumb to consider. Nothing in the world remains static, including how a business uses equipment. “After two years, almost all the time you’re going to want to upgrade or downgrade,” says Arleen Kahn, president of AMK Associates, a New York-based cost-management firm. Even if equipment will hold its value, a business might find it no longer suitable. Kahn tells the story of a client who had purchased a copy machine before downsizing the company. “He went from three floors to two floors to one floor,” she explains. As the number of employees dropped, so did the demands on the copier. The copier was still valuable, but was too much for the downsized company.
Had the client leased the copier, the company might have traded it in and taken something smaller. With a lease, the lessor—whether a bank or dealer—still owns the equipment and cannot effectively ignore you because it has a stake in case of a problem. With many types of equipment, dealers are willing to do buy-outs of an old lease to sell a company into something with more capacity (read: more expensive) by spreading the remaining payment total over the life of the new lease. For that reason, Kahn suggests that, if you are leasing, take an agreement no longer than three years—enough time to pass the two-year change mark, but not so long that the total buy-out adds too much when spread across the monthly payments.
If equipment is under $5,000, Kahn generally suggests buying, if possible, because the replacement costs may not be worth the interest expense of a lease. Even if purchasing is the best strategic decision, Kahn suggests considering a one-year lease with a buy-out option at the end. Business equipment often has a 90-day warranty. The one-year lease, while adding some interest, becomes a way of effectively getting an extended warranty without committing to a multi-year service contract. “Let’s say something really goes wrong with that piece of equipment and you feel that they’re not responding to your needs after the 90-day [standard warranty],” she says. “You have leverage.”
Under rare circumstances, says Winmill, a business should consider an operational lease, which is an arrangement with no end-of-term buy-out available to the business owner. In effect, an operational lease is a long rental arrangement under which you basically finance the equipment for the dealer. Afterward, the dealer sells the used equipment and gains the equity as further profit. “You’re playing poker with a guy named Doc,” Winmill says. That’s fine if you absolutely know
that owning the equipment would make no sense, but if there is a chance you will want to hold on to the equipment, then it’s a big mistake. A related issue is watching the buy-out price. If the lease agreement refers to a fair market value, there should be some specified way of determining that number, otherwise you could be leaving your final payment up to the whim of the lessor.
A related issue is watching the buy-out price. If the lease agreement refers to a fair market value, there should be some specified way of determining that number, otherwise you could be leaving your final payment up to the whim of the lessor.
Ten Questions To Ask
Leasing equipment can been tricky, especially if you’re leasing for the first time. The Equipment Leasing Association recommends businesses ask the following 10 questions before signing a lease. These questions take into account the “before, during and after” stages of a lease.
1. How am I planning to use this equipment?
2. Does the leasing representative understand my business and how this transaction helps me to do business?
3. What is the total lease payment and are there any other costs that I could incur before the lease ends?
4. What happens if I want to change this lease or end the lease early? Is there a penalty?
5.. How am I responsible if the equipment is damaged or destroyed?
6. What are my obligations for the equipment (such as insurance, taxes and maintenance) during the lease?
7. Can I upgrade the equipment or add equipment under this lease?
8. What are my options at the end of the lease?
9. What procedures must I follow if I choose to return the equipment?
10. Are there any extra costs at the end of the lease?