Equipment finance accounts for a substantial portion of all investments by U.S. enterprises in capital goods. Nonetheless, management of equipment financing is often not given sufficient emphasis within enterprises.
To gage the effectiveness of its equipment finance management, enterprises should take a close look at these five aspects of their equipment financing program—each of which is essential to minimizing equipment financing cost and risk.
Procurement decisions. A comprehensive analysis of the all-in costs of leasing will provide an enterprise with the knowledge and insight necessary to perform an accurate lease vs. buy analysis and make better lessor selection decisions.
Negotiation for favorable lease terms. An equipment financing program should be focused on minimizing lease-agreement language that exposes the lessee to unnecessary risk. Common clauses that increase risk include:
- End-of-lease equipment return conditions that are extremely difficult to comply with.
- Lessor-favorable mechanisms for determining fair market value for the lessee’s purchase of the asset at the end of the lease.
- Burdensome and time-consuming notice requirements that can easily lead to non-compliance that results in penalties and lease extensions.
- Fees in additions to rent.
- Uncapped interim rent.
- Default provisions that place the lessee at significant risk of default.
Without an awareness of these potential risks, an equipment financing program’s budget can be severely compromised.
Notice reminders. Lessors should be required to give the lessee "notice of its notice" in some reasonable period before a notice from the lessee is required.
Data visibility. Using lease schedules to closely track costs provides an enterprise with the information necessary to conduct accurate lease vs. buy analyses and vendor evaluations. This data also enables an enterprise to identify and correct issues that are escalating lease costs and exposing the enterprise to avoidable risk.
Expertise in equipment finance. The equipment financing industry is complex and specialized, and adequately managing an equipment finance program requires an in-depth understanding of the intricacies involved. Many enterprises, however, rely on critical equipment finance decisions to be made by people whose primary job function isn’t equipment finance management and who don’t have the specialized expertise necessary to make accurate analyses, structure lease operations, and limit risk in lease agreements. (Lawyers who aren’t well-versed in lease agreements can’t be counted on to identify the risks either.)
Without the necessary expertise in-house, many enterprises wisely turn to equipment finance professionals for assistance.
Equipment financing is a vital operation that requires resources, attention, and knowledge to properly manage. When properly managed, equipment finance can be an excellent, low cost tool for capital needs. When not properly managed, equipment finance costs can rapidly spin out of control.
Leasing business equipment often seems to be a less-expensive procurement option than purchasing, but that determination may not be accurate if the true risks of equipment leasing aren’t factored into the lease vs. buy analysis.
Failing to recognize risk can also lead to unwise lessor selection, based almost solely on rate and not the actual all-in costs of the lease.
For these reasons, enterprises that are considering leasing their business equipment need to be able to identify all risks and quantify the associated cost based on historical lease performance.
The pitfalls of leasing business equipment are many, but these five risks are among the most common that cause business equipment costs to escalate well beyond the cost of the lease term rent.
1. Soft costs.
Services, software and other "soft" costs will vary depending on the type of office and kind of equipment, but they can be substantial. There are two main issued with soft cost: 1. Lessors generally do not invest any equity into the soft costs, so therefore lessees are paying for 100% of the soft costs over the term, plus interest and additional lease costs. 2. In some cases, soft costs can create significant end of lease risk (lessors may require that software be returned just like hardware) unless treated differently than returnable assets.
2. Fees and charges.
Many business equipment leases contain various service fees (administrative fees, restocking fees, security deposits, etc.). If these fees are not reasonable and capped, they can become a significant, ongoing drag on income. In many cases, lessees end up paying more for service than they could if they had purchased the equipment and hired a third party for service management.
3. Using the wrong lease structure for the asset type.
For example, a fair market value back-end lease should never be used for vehicles when a form of TRAC (Terminal Rental Adjustment Clause) lease is available, because the risks are too great and costs can spiral out of control. In a TRAC lease, the residual value for the leased vehicle is established at the beginning of the lease. At the end of the lease, the lessee can buy the vehicle or continue leasing by financing the predetermined residual value. If a lessee structures the lease agreement properly, it will also be able to return or trade equipment during the lease.
4. Being unable to return the business equipment because it’s too distributed.
Particularly with IT equipment, the equipment can be so dispersed that return is virtually impossible from a logistical perspective, especially to the contract specifications. Many times, lessees literally don’t know where all the equipment on a lease schedule is located.
Additionally, the equipment will likely be used in varied ways, some of which are fulfilling urgent and ongoing needs. This variety of use can easily lead to difficulty in coordinating a return. The departments using the equipment often aren’t ready to part with it when the lease ends.
5. Being unable to uninstall large pieces of equipment.
Sometimes the problem isn’t locating the equipment for return. Large pieces of vital equipment will be “right there.” But many times, this large equipment can’t be returned on time per the contract terms because it would derail operations. When equipment is not returned on time and a lease extends, the underlying economics of the lease rapidly get flipped upside down.
Business equipment leasing has many risks — many of them related to end-of-lease terms. Before entering into any lease for business equipment, an enterprise needs to thoroughly understand the historical cost implications of lease risk, make a realistic assessment of the probability of return, and cap risk exposures in the leasing terms in the underlying equipment lease agreements as much as possible.
Leasing can be the most financially sound equipment-procurement option for enterprises. However, equipment leasing is a complex process, full of intricacies and risks. The equipment leasing process must be handled properly to gain the full advantages and to prevent costly missteps.
Unless an enterprise has highly experienced in-house leasing expertise, it can benefit greatly from hiring an equipment leasing professional.
Here are five reasons why:
1. Lease vs. buy analysis.
Professionals with leasing expertise can help enterprises accurately compare the cost of leasing to the cost of purchasing. In many organizations, the all-in costs of leasing aren’t adequately tabulated, with less-obvious costs (driven by obscure contract terms) left out. With the help of an evaluation by someone who understands all the costs of leasing, an enterprise can make smarter financial judgments about which equipment-procurement option is best.
2. Vendor evaluation.
Without an expert knowledge of all the elements that constitute total leasing costs, it’s impossible for an enterprise to adequately compare vendors to find the best value. Informed vendor selection involves a lot more than comparing the cost of base rent.
Leasing experts can help enterprises evaluate the finer details of lease agreements in order to adequately understand the costs and risks and choose vendors more wisely. They will ensure that you are making an apples to apples comparison of potential lessor partners.
3. Negotiation of terms and conditions.
During the negotiation of lease agreements, knowledgeable leasing assistance can help enterprises avoid terms and conditions (e.g., uncapped interim rent charges) that can cause dramatically increased program cost.
An enterprise that enters into lease agreements without an in-depth understanding of additional that costs can potentially accumulate is putting itself at great risk of suffering unnecessary and unexpected expense—particularly when it comes to end-of-lease contractual language such as extension terms, buy-out clauses, fair-market valuation definition, and return-of-equipment requirements.
An enterprise's entire equipment-procurement strategy can be compromised if the enterprise doesn't have the capability to negotiate lease agreements that protect it at the end of lease. Equipment leasing professionals provide that capability.
4. Long-Term Strategy and Operational Improvement
In many enterprises, leasing is handled piecemeal, with various areas of the company negotiating and managing leasing activities. With the assistance of a leasing specialist, all leasing activity can be coordinated to achieve ongoing efficiencies from negotiation approach to operations. Best practices can be implemented enterprise-wide.
A comprehensive strategy and consistent corporate policy regarding leasing will reduce risk, costs, and disruptions. Experienced leasing professionals can provide the necessary guidance in the development of such a unified, cost-effective, continuous improvement based leasing program.
5. Problem Resolution
When an enterprise has stumbled into a leasing situation where it’s facing unexpected and excessive leasing costs—usually at the end of lease—an equipment leasing professional can step in to stop the bleeding. Equipment leasing professionals “know how the game is played” and they can often find solutions not obvious to those without leasing expertise.
Expertise in the intricacies of equipment leasing is necessary to minimize equipment leasing risks and costs. If you don't have this expertise in-house, you can create significant budget savings by working with a third-party expert.
There is a common perception—particularly for IT equipment—that leasing is an easier, more efficient and more cost-effective way to procure equipment than using commercial business loans or other forms of debt to purchase the equipment.
There are several reasons for this view:
- If risk is properly capped in lease agreements, leasing can generally allow an enterprise to pay only about 90% of the original equipment cost (OEC) and then return the equipment, when it has relatively little, if any, useful life left. This is seen as a way to avoid the cost of technical obsolescence.
- Many CFOs prefer to preserve their enterprise’s commercial lines of credit for needs that they deem more business-critical.
- Using commercial lines of credit can put an enterprise out of compliance with bank covenants.
- Leases classified under current U.S. accounting rules as operating leases can be kept off the balance sheet, improving key financial metrics.
Commercial Business Loans: No Strings Attached
It’s true that equipment leasing companies will generally offer lower lease rates than the interest rate received on commercial business loans. But a lease rate is not the same as the interest rate from a bank. To determine the actual financing cost of a lease, an enterprise must look at all costs associated with the lease—fees, penalties, interim rent, lease extensions, buyout cost, etc.
When evaluated in this manner—with full financial analysis as opposed to a simple comparison of lease rate vs. interest rate—commercial business loans become much more appealing. Enterprises are often enticed by the opportunity to lower equipment costs by entering into low-rate leases and successfully managing the high risk that lease agreements contain — but if an enterprise fails at this effort, the result could be disastrous. It’s not uncommon for enterprises that lease equipment without controlling risk to pay as much as two times as much for equipment as the original equipment cost (OEC).
Commercial business loans, on the other hand, are generally “no surprises” transactions. Risk is virtually nonexistent—the interest rate is the cost, and that’s it. And commercial business loans provide a critically important additional benefit—the enterprise has control over its equipment refresh schedule, keeping it from losing leverage by being tied to a lessor’s lease schedule.
Making a Choice
So the crux of the decision between commercial business loans and equipment leases is the capability of the enterprise to adequately identify and control risk in lease negotiations and operations. Enterprises need to realistically assess their aptitude at negotiating to reduce risk in lease agreements and seek expert assistance if needed. Assumptions about returning equipment and achieving other operational goals (e.g., meeting notices, paying on time) should be measured against the historical record to determine how realistic they are.
The situation in equipment leasing today is that unless a lessee works with an expert to cap risk and cost of leasing most enterprises will find commercial business loans more cost-effective. Unless an enterprise is very well-prepared in terms of leasing agreement expertise and operational capabilities to actually achieve the cost savings promised by equipment leasing leasing will be the higher cost alternative.
Failing to understand and give appropriate weight to the risks of equipment leasing can have dire consequences. When risks aren’t capped in lease agreements and managed during operations, enterprises often end up paying multiple times as much for equipment than if they had financed the equipment through a commercial loan.
Enterprises that want to pursue the cost savings possible with equipment leasing can be successful with this strategy—but only if they are well-armed with knowledge about the substantial risks involved and how to minimize them.
A major change in equipment lease accounting is on the way, doing away with the current accounting treatment. The U.S. Financial Accounting Standards Board is revising its FASB 13 standard—which deals with capital vs. operating classification—to be more in line with international standards.
The lease accounting revision has been in the work for many years, and just last week the IASB and FASB released the redraft of the Exposure Draft (ED). This ED will be open for public comment through September, and afterward there will outreach and redeliberations that could take months or even years. So while the final standard and effective date is still TBD, it is safe to say that the changes are imminent, and enterprises are already making adjustments.
LPRS will be posting a series of in-depth blog posts breaking down the implications of this new ED over the next few weeks and months. But in the short term, enterprises need to understand three critical financial and risk implications of this interim period before the implementation of the new standard.
1. “Capital” leases are no longer synonymous with low-risk.
Actually, this is already occurring. Many CFOs and other decision-makers are preparing for the upcoming accounting changes by mandating that all leases must be capital leases. This will get all leases on the balance sheet and is popularly thought to also reduce lease risk.
Traditionally, capital leases have been very low-risk, with higher rental rates than operating leases. But, with the both the advent of Sarbanes-Oxley and subsequent movement to capital leases in anticipation of the accounting changes, many equipment leasing companies are selling so-called “capital leases” that contain the risk traditionally associated with operating leases.
This is possible because of the FASB’s current “Bright Line Test” for whether a lease is capital or operating. There are four cases in which a lease must be considered capital, and equipment leasing companies can structure leases so that they must be considered capital leases, even though they still contain a great deal of risk.
Lessees should be careful not to be fooled into confusing one of these “capital” leases with a traditional low-risk capital lease. They have the risk of operating leases, and enterprises should be careful of placing too much value on the capital classification, even in light of the looming accounting changes. There are advantages to capital classification, but they must be considered in light of the full risk that the lease contains.
2. Once the FASB 13 changes take place, equipment leasing companies will likely increase the terms and conditions which generate lease risk.
Under the new lease accounting, all equipment leases (known as "Type A" leases) will be on balance sheet and all equipment leasing companies that previously relied on higher rates to compensate for low-risk leases may now be compelled to introduce additional lessee risk into their leases. In addition, the increased competition for relatively low-rate leases will encourage companies that already include significant lessee risk in their lease agreements to seek to add even more.
3. Risk measurement will be more important than ever.
In this new environment, which is already taking shape, enterprises must be more diligent about identifying and measuring the risk contained within lease agreements. Lease financial risk is triggered by lease terms and conditions which cause lease extensions, penalties, interim rent, etc.—and it takes an in-depth knowledge of lease agreements and all the forms of risk that they can contain in order to adequately make assessments about lease vs. buy and vendor selection, as well as to negotiate favorable terms. Many times, this expertise must be resourced from outside the enterprise.
Look out for a series of upcoming blog posts which will break down the new proposed equipment lease accounting rules in detail.
CFOs and other key people involved in equipment procurement frequently get approached by commercial equipment leasing companies promising “great rates." These salespeople will freely share their “expertise” on equipment leasing, explaining how the flexibility that their equipment leasing solution offers will reduce equipment costs and offer countless other benefits.
Other times, the equipment leasing companies are the ones getting the calls, from businesses faced with a sudden equipment need and searching for the least-expensive monthly solution. In such cases, the equipment leasing companies gladly act as “consultants.”
But it’s important for potential lessees to understand what leasing companies typically leave out of their advice—the most important drivers of risk in equipment leasing.
Enterprises can get a good deal through equipment leasing, paying only about 90% of original equipment cost, as well as getting favorable accounting treatment in the case of operating leases. But this savings depends on avoiding risk factors the equipment leasing companies don’t like to talk about, such as the financial repercussions for equipment not being returned on time or required notices not being met.
When selecting an equipment leasing company, the onus is on the lessee to evaluate the risk in each lease proposal it receives.
Plan Ahead Instead of Reacting
The foundation for selecting the best equipment leasing company is a comprehensive equipment procurement strategy. When enterprises are forced to react to sudden equipment needs, they usually don’t have the time or the allocated resources to perform full contract risk assessment and financial analyses of competing lease agreements. Therefore, leasing decisions are often driven by the lowest rate or convenience, rather than the lowest likely all-in cost.
Rate Isn’t the Full Story
When comparing equipment leasing companies, the key principle to understand is that the lease rate factor (LRF) is not the same as an interest rate. There will be other costs beyond rent embedded within any operating lease agreement, as well as within many capital lease agreements that aren’t properly structured. These costs must be included to determine the true financing cost for the equipment.
An enterprise should research and document its historical leasing costs—all costs, not just the sum of rental payments. With that information, an enterprise can conduct a lease vs. buy analysis that reflects reality, allowing accurate determinations of whether leasing is even the best option in a given situation. And if it is, that data allows for better comparisons of competing lease proposals.
Enterprises that successfully select the true lowest-cost equipment leasing companies almost always:
- Conduct full financial analysis of all lease proposals. Comparing LRFs simply isn’t enough—determining the implicit rate of a lease requires determining the likely all-in cost. This should include estimates of interim rent, other fees and deposits, extension rent, fair market value, and non-compliant return charges.
- Pay attention to contract details. To scope the likely all-in cost the many risks in lease agreements must be defined. Astute enterprises often hire equipment leasing experts to review lease proposals.
- Control the calendar. In evaluating lease proposals, enterprises serve themselves well by retaining control of the timing of each stage of the lease life cycle including vendor selection, return schedules, payment schedules, and other timing issues that have a substantial impact on whether the lessor or lessee has leverage.
- Use a mix of equipment leasing companies, equipment vendors, and banks for their leasing. Each lease vendor type can offer advantages in various situations. The best deal can often be found with an equipment leasing company—if all risk is suitably capped. But equipment vendors can offer much-needed expertise in highly specialized equipment, and relationships with banks in other areas can sometimes give an enterprise some leverage.
Selecting the best commercial equipment leasing company involves understanding the risks in lease agreements and the historical all-in cost of these risks—and then devoting sufficient time and resources into comparing lease proposals based on this knowledge.
In equipment leasing, the popular understanding of difference in cost and risk between a capital lease and an operating lease has been that capital leases have higher rental rates but virtually no end of lease risk, while operating leases have lower rates but considerable end of lease risk.
The operating lease classification is appealing to many enterprises because it keeps the equipment cost off the balance sheet, improving critical financial ratios. But the relative benefits of operating leases can only be achieved with diligent attention to minimizing risk in the lease-agreement negotiations. Enterprises must be cautious that they do not forsake sound financial decisions for short term accounting benefits.
What’s In a Name?
Adding to the complexity of the capital vs. operating lease decision is the fact that the terms don’t necessarily have the meaning which they are traditionally understood to have. In many cases, leases that are classified as capital leases are in essence risky operating leases, dressed up as capital leases.
This confusion is made possible by the U.S. Financial Accounting Standards Board’s Bright Line Test, which requires a lease to be categorized as a capital lease if just one of these conditions is true:
- The lease automatically transfers ownership of the equipment to the lessee at the end of the lease.
- The lease contains a bargain purchase options.
- The lease term covers more than 75% of the estimated economic life of the equipment.
- The present value of the minimum lease payments (discounted using the lessee’s internal borrowing rate) exceeds 90% of the fair value of the equipment.
These conditions were put in place to keep leases from being inappropriately kept off the balance sheet. But the bright line tests also make it easy for lessors to structure lease agreements to be considered capital leases, even if they still contain a great amount of risk.
In anticipation of the FASB / IFRS convergence accounting changes which will likely put all leases on the balance sheet and do away with current capital and operating classifications, many CFOs and other key decision-makers are mandating that their organizations use only capital leases. The risk in this approach is assuming that the “capital” classification guarantees low-risk. That’s simply no longer true. After all, a Capital Lease is simply a lease which meets ONE of the bright line requirements laid out above.
Capital or Operating Lease—Specific Risks Must Be Assessed.
Regardless of whether the lease is “operating” or “capital”— lessees need to have equipment leasing experts thoroughly examine any lease agreement for the potential risks it contains. Is there still a FMV back-end structure, or is it a $1 out? The $1 out agreed upon end of lease purchase terms of a capital lease may be structured not as an agreed upon outcome but as only an option. To execute the $1 buy-out option the lease may require notice be made, default has not occurred, along with several other requirements. If these terms are not adhered to the $1 out option may become unavailable and other costs accrue driven by other terms and conditions including:
- Notice requirements that make compliance tremendously difficult. Many lease agreements contain provisions that require the lessee to provide notice for normal operating activities. Often, the notice must be given in a very short (and unintuitive) time frame, by precise methods. Failure to provide the notice in the stipulated time frame then triggers penalties and potentially costly lease extensions.
- All-but-not-less-than-all clauses that can easily lead to lease extensions. Lessors often include an all-but-not-less-than-all clause, which requires every piece of equipment on a lease schedule to be returned or else full rent continues on the entire schedule.
- Lessor control of a fair market value for purchase at end of lease. If the definition of FMV favors the lessor, that’s obviously isn’t good for the lessee. But lack of clarity about FMV can also favor the lessor, which will be happy for negotiations over FMV to drag on as the lessor has to continue making lease payments.
Properly structured capital leases contain less risk than operating leases, but many of the capital leases available today are not structured in the "traditional" way. Instead, they pose considerable risk that requires experience with lease agreements to identify.
Enterprises that enter into an equipment lease agreement without a clear understanding of the risks involved almost always end up paying more than they should. Equipment leasing companies are well aware of how to increase their potential revenue by structuring an equipment lease agreement to increase lessee risk. To protect themselves, enterprises need to understand what these risky lease agreement terms are.
1. Uncapped interim rent.
Most equipment lease agreements allow the lessor to charge rent for equipment that’s delivered and accepted before the official commencement date of the lease. Usually this rent is at the full rate (pro-rated for days used). The problem for lessees occurs when they fail to cap the amount of this interim rent. Without such a cap, equipment leasing companies can collect substantial additional rent without any adjustment to the amount of regular term rent owed.
2. Fees for non-compliance.
Equipment leasing companies frequently include provisions that are difficult for lessees to meet, leading to additional costs. For example, equipment condition and packaging requirements (for damages, inspection prior to return, etc.) can sometimes be so stringent that non-compliance is likely. Lessees need to carefully examine any lease agreement for such overly burdensome requirements that can lead to penalties, and these clauses should be resisted.
3. Easy default.
Defaulting under an equipment lease agreement gives lessors a tremendous amount of leverage in future negotiations. For this reason, it’s imperative for lessees to structure any lease agreement so that the risk of default is minimized. If there’s any proposed lease agreement language that would allow default to happen “by accident” or by circumstances that could easily occur during normal operations, clauses that can trigger default, such as "failure to meet any obligation under the lease," should be eliminated.
4. Lease extensions.
Lessors usually prefer that lessees extend leases rather than return equipment. One way that they typically accomplish this within an equipment lease agreement is to include an “all-but-not-less-than-all” provision for equipment return. This means that the equipment leasing company can continue charging full rent for an entire schedule until every single piece of equipment (serial-number specific) on that schedule is returned. This can be a very difficult, if not impossible task for lessees particularly when leasing distributed assets such as technology equipment. The threat of default can also be used to encourage lease extensions.
5. Poorly defined fair market value at end of lease.
Many equipment lease agreements will allow the lessee to buy the equipment at fair market value (FMV) at the end of the lease, as opposed to returning the equipment (which often isn’t practical) or extending the lease. But if the lease agreement essentially allows the equipment leasing company to determine the FMV, then it can effectively take the purchasing option off the table for the lessee. If the equipment can’t be returned, the lessee is left with no recourse but to extend the lease, unless it’s willing to pay the inflated FMV.
Lessees can seek to limit this risk by insisting on mutual agreement on FMV. But this process of mutual agreement must be clearly spelled out and limited in time length, or else the lessee will probably still end up paying lease extensions that it didn’t figure into its equipment cost projections. Because the lessee will continue paying rent while negotiations proceed, the lessor has no incentive to reach an agreement.
These are just a few of the risks that lessees face when entering into equipment lease agreements. To adequately review a lease agreement, an enterprise needs to have in-house leasing expertise or contract with an equipment lease specialist. The resulting cost savings from a thorough, informed review of lease agreements can be considerable.
Equipment leasing can be a financially prudent method of procuring hospital equipment and related hospital supplies and services for hospitals and other health care related organizations. However, many medical providers enter into leasing agreements without an awareness of the all-in costs of leasing or the risks involved.
To protect themselves and secure the most favorable lease terms, medical providers need to approach the leasing of hospital equipment and related hospital supplies and services with a systematic, strategic plan for minimizing leasing risks and costs, while ensuring that the equipment needs of the enterprise are met. But leases for hospital equipment and related hospital supplies are complex, making the astute management of the leasing process a challenge.
Central role of Finance/Treasury in vendor selection and management.
Particularly for hospitals or other large health care provider organizations, leasing of hospital supplies is commonly not centralized, with individual departments often operating in "silos"--choosing and evaluating vendors and leases with little regard for corporate-level policy or consistency. In many cases, this is because there is no corporate-level policy, or at least not a policy sufficient to standardize leasing activity across all areas of the organization.
The result of this lack of central leasing control inevitably leads to contracts being signed that have avoidable and unacceptable risk. It also often means that efforts to control costs through careful vendor selection have not been followed. Without an enterprise-wide leasing policy, including best practices and centralized lease approval, there is no mechanism for enforcing lease cost containment. While various parts of the organization may make wise decisions about leasing hospital supplies, others may make costly decisions.
The solution is to centralize the leasing of hospital equipment and related hospital supplies and services within the finance/treasury department. The approval process should be standardized, including standards for lease schedule language by asset type (developed by treasury/finance). This centralization should also include performance monitoring as leases conclude, to identify opportunities to control risks and costs, as well as to evaluate vendor performance.
Implementation of company-wide best practices.
The key point that hospitals and other health care providers need to grasp is that all areas of the organization should be following the same best practices. In order to identify these best practices, the enterprise (lead by treasury/finance) needs to perform an analysis of past leasing performance, being sure to pinpoint the all-in costs of leasing; not just the sum of the rental payments.
The performance data brought to light through such an analysis of historical lease performance enables the enterprise to effectively conduct lease vs. buy analysis, to determine if leasing is in fact the best option.
When an enterprise is considering leasing equipment, the type of equipment being leased makes a big difference when conducting lease vs. buy analysis, selecting the right leasing structure and related accounting treatment (operating or capital), and choosing leasing vendors.
For example, two of the most common leased asset types are trucks and IT equipment, but the best practices for truck leasing and IT equipment leasing aren’t the same.
With truck leasing, traditional operating leases are almost never a good idea. The risks are great to the lessee, and costs can escalate too easily.
Capital leases are an option for truck leasing, but they come with a higher rate than is necessary for an enterprise too pay. Instead, the enterprise can cap risk by insisting on a Term Rental Adjustment Clause (TRAC) in the truck leasing agreement. The enterprise won’t be able to keep the truck leasing expense off the balance sheet, but the rate will be lower than a capital lease and there is virtually no risk.
The key element of a TRAC is a pre-established residual value for the trucks. At the end of the lease, the lessee can buy the equipment at that price or continue to lease by financing the predetermined residual value. With a properly structured TRAC, there are also provisions for returning or trading equipment, with adjustments made based on the equipment’s resale value vs. the residual value.
There’s an inverse relationship between the amount of the predetermined residual value and rental rates. In general, the higher the residual value, the lower the rates. This provides cash flow flexibility. TRAC lease master lease and supporting documents can also be strucutred to provide a strong case for receiving off balance sheet accounting treatment. The key lies in how the residual and term rental structures are defined. Advice from accounting professionals is critical in evaluating such structures.
Within IT departments, there’s a misguided notion that operating leases protect the lessee from the risk of technical obsolescence. It’s true that operating leases theoretically shift the risk of obsolescence to the lessor, but in reality, operating leases confine the lessee to the refresh cycle dictated by the term of the lease agreement. This can be a costly loss of flexibility.
When procuring IT equipment, buying it outright is actually and putting the assets on regular refresh cycles internally is actually the way to maintain the flexibility to upgrade at the most cost-efficient time.
But when a cash purchase isn’t feasible, lessees can still protect themselves against risk. The key is to focus on issues beyond the rate and cap exposure to interim rent, retainable deposits, extensions, end of lease buy outs and other events such as default and non-compliant equipment return.
Equipment leasing decisions must take into account the asset type being leased. As this example of truck leasing vs. IT equipment leases illustrates, there are specific strategies that need to be employed for each type.