As bankers and business owners can attest to, we are in a time of significant fluidity in the lending market. After nearly a decade of consistently and historically low interest rates, the Federal Reserve has raised rates regularly throughout 2017 and 2018. Furthermore, strong indications exist that additional rate hikes are probable in 2019. Given the rising costs associated with borrowing the funds necessary to purchase machinery and equipment, the use of leasing arrangements may emerge as a more appealing alternative for companies to use to meet these needs.
When deciding whether to enter into a leasing agreement, here are five key factors to consider:
1. Assess the Cash Flow Impact
Given that a lease does not provide the lessee with the full benefits of owning the asset, the arrangement should offer the lessee other advantages. One particular area in which prospective lessees should seek upside is that of cash flow. Before entering into a lease agreement, it is prudent to compare the monthly rental payments with the payments of principal and interest that would be required if the company borrowed funds and purchased the asset. If the outflows entailed in the lease exceed, or are even comparable to, those associated with debt, then financing may prove to be the superior option.
2. Compare the Asset’s Useful Life to the Lease Term
Unlike ownership, which enables you to utilize the asset indefinitely, leasing limits your use of the asset to a fixed time period. This limitation makes it especially critical for a prospective lessee to (a) ensure the accuracy of its estimate of the asset’s useful life and (b) verify that the lease term sufficiently meets its needs and expectations for use of the asset. A lease term that exceeds the asset’s useful life will commit the company to paying to use the asset after it is practically viable to do so. Conversely, a useful life that exceeds the lease term may result in a company’s ability to use the asset terminating while there is still a need for it. The inclusion of lease extension or purchase option provisions within the agreement can mitigate these risks.
3. Consider the Tax Ramifications
Tax reform legislation enacted in December 2017 contained special provisions such as increased Section 179 expense and 100% bonus depreciation on fixed assets and equipment. These provisions could make purchasing the asset more cost effective than leasing (despite the increased borrowing costs) due to the tax savings that might be captured from the purchase.
4. Review your Existing Financial Covenant Calculations and Requirements
Leases impact financial covenant calculations in very different ways than debt instruments do. These differences can either be a positive or a negative, depending on the specific covenants that pertain to your business. Before entering into a major lease, ensure that you are familiar and comfortable with the impact that it will have on your covenant calculations going forward.
5. Prepare for Accounting Changes
The accounting for leases will become more complex and extensive in the near future. New accounting standards, which become effective on January 1, 2020 for private companies, will require all leases with terms of 12 or more months to be recorded on the balance sheet, including the recognition of both a right-of-use asset and a lease liability. These requirements represent a stark change in the current accounting for many leases, which simply consists of recording a monthly expense on the income statement related to the lease payments.
Assessing the matters noted above when deciding whether to purchase or lease equipment will assist you in making successful long-term operational and financial decisions regarding your business.