Does it make more sense to lease business equipment or buy business equipment? As we slowly and tentatively ease into what the talking heads on TV are calling an economic recovery, you may be thinking about upgrading that outdated processing equipment and getting a new machine that’s better and faster. Perhaps you even see your backlog increasing again and you’re realizing you have ridden your existing capacity until the wheels are falling off, and if you want to grow the business, you need some equipment. It might be wet process equipment, machine shop stuff, forklifts or new PCs for the office, and depending on what it is, your situation and plans, there are a several options to consider so that you can put the equipment in place and start using it, immediately.
Leasing equipment is generally a better option for manufacturers who have limited out-of-pocket capital and where business needs require upgrading equipment every few years. Office computers and copiers, for instance, are often leased strictly to avoid obsolescence every few years. Purchased equipment may be a better choice when the useful life of the equipment lasts more than five years. Interestingly enough, there are leasing programs available that end in equipment purchase at term that still minimize up front cash required. Each company situation is unique and you should make decisions on a case by case basis.
The primary advantage of leasing is that it allows you to acquire assets with minimal initial expenditures. Because leasing rarely requires a downpayment, you can obtain and make use of the equipment you need without significantly affecting your cash flow. This frees up cash for operations or other investments. Another financial benefit of leasing, if you have a straight operating lease (read that equipment rental contract), is that your lease payments are generally 100% deductible on your corporate tax return in the year they are paid as an operational expense of the business. This effectively reduces the net cost of the lease and should be considered. Leases for manufacturing equipment are usually easier to obtain and have more flexible terms for buying equipment than do loans, and this can be a tremendous advantage if you have poor credit or need to negotiate a longer payment schedule to ease the burden on your monthly cash flow.
Leasing also addresses the problem of equipment obsolescence. If you secure machines with your lease that become technologically outdated within a few years, a lease passes that burden to the lessor, and gives you the freedom to lease newer, higher end equipment at the completion of the lease term. Similar to obsolescence, many manufacturers are awarded multi-year contracts by industry or government (DOD, etc.). A typical lease relieves the manufacturer of the burden of owning equipment he will no longer use upon completion of the contract. If the contract is renewed or extended, so may be the lease, or alternate options become available. In fact, a lease is a nice option for any situation where the long term viability of a current business opportunity is uncertain, such as trial entry into new markets, products, etc. Translation: maximum flexibility.
A straight equipment operating lease means you don’t own the equipment, you are paying for its use over the course of the lease. You can relate to automobile leasing, and at the completion of the lease, just as with cars, you have an option to buy the equipment at a fixed price, usually the fair market value.
As I hinted at earlier, there are also less traditional leases with higher payment terms that result in a buyout at 10% of purchase or $1, and this is more akin to traditional financing, except that there are still low down payments and flexible terms. For tax purposes, these leases are treated as capital purchases and enjoy the tax benefits of ownership (such as section 179 advanced depreciation rules, see Buying).
Leasing equipment has two primary disadvantages: overall cost and lack of ownership. Leasing a piece of equipment is almost always more expensive over the long haul than purchasing it outright. For instance, a 3-year lease on computer equipment worth $4000, at a standard rate of $40/$1000 price, will cost you a total of $5760, whereas purchasing it outright costs $4000. In addition to the higher cost, you will have built no equity in the computers on a FMV (Fair Market Value) lease. Unless the equipment has become totally obsolete at the end of the lease, this is a significant drawback. In this example, even as fast as computers lose their value upon leaving the store, they would still have some residual value at the term of the lease.
Here’s another downside to leasing that many people have a hard time getting their head around when also considering loans. You are obligated to make payments for the entire lease period even if you cease using the equipment. Some leases provide the option for early cancellation if the business shifts direction during the term, but substantial cancellation fees almost always apply. There is also not much advantage to pre-pay off the lease, as you don’t gain any interest advantage, you simply are paying the same amounts early. The one exception to this is tax advantages. See your tax accountant on options for accelerating lease payments to obtain more expense deductions in high income years.
Advantages of Buying
The clearest advantages of buying manufacturing equipment is the ownership you enjoy after the purchase. This is especially true when the property has a long useful life and is not at risk of technological obsolescence in the near future, such as heavy fabrication or machine shop equipment.
There is another advantage that applies to purchases, whether paid for with cash, financed with a loan, or a $1 buyout lease. Section 179 of the tax code allows first year complete deduction of equipment necessary to the business up to certain limits (IRS changes these yearly) as opposed to multi-year depreciation or deduction of lease payments. Even if you are paying a $1 buyout lease over 5 years for $100,000 worth of equipment (if your total is under the set limits), you can fully deduct it in the first year. For this example, if you are in a 25% tax bracket, that equipment really only costs you $75,000, because you write off $25,000 in the first year you put it into service. This should be a significant motivator that, no matter how you finance the equipment, if you need equipment for your business growth or sustainability, by all means max out this deduction.
Disadvantages of Buying
When you purchase a capital asset via conventional equipment loan, it goes on the company balance sheet as a liability. The only tax advantage you receive if you are beyond your section 179 limitations is annual depreciation. Depending on the equipment and its depreciation schedule, this may not be nearly as much financially as the payments on, say, a three year operating lease. If you pay cash for the equipment, obviously you bear the opportunity cost of the money you could have spent on operational expenses or other opportunities.
Then as highlighted earlier, there is the problem of outdated equipment. You may find yourself at the end of an equipment loan owning an asset that has very low market resale value because it is technologically obsolete. Now you have to repeat the process and reinvest in new equipment again. Recall the computers example earlier for $4000. If not purchased with cash, you go through the pains of paying interest and financing a larger amount, only to be left with equipment in 3 years worth a thousand dollars or so. This is why many companies lease rapidly depreciating equipment that, as a general rule, is always being updated with higher technology.
If financing a purchase via an equipment loan, understand also that approval time for loans is usually longer than for a lease, with more in-depth financial disclosure. If your company has an opportunity to capitalize on a quickly developing opportunity and you don’t want to part with cash (or don’t have it), financing via a loan may not be the best option.
So What Should You Do?
When making the decision to purchase outright, take out an equipment loan, or lease a piece of manufacturing equipment, first determine the approximate net cost of the asset. Factor in the tax breaks, opportunity cost of cash, and resale value we have talked about in this article in addition to total price paid. After determining which option is most cost effective, roll in intangible factors such as equipment obsolescence or whether the need for the equipment will cease before the term of a lease or loan. No one likes to pay for something they are no longer using.
The following table illustrates some quick reference pros and cons of various ways to buy new equipment:
|Interest Rates||Fixed Rate||Can fluctuate with the market||Fixed or floating||None|
|Speed of Approval||Within two business days for most amounts||Days to Weeks||Days to Weeks||Instant|
|Down Payment||Typically, only one or two payments up front which are applied to your balance||Typically, 10-20% of the total amount||Typically, 10-20% of the total amount||100%|
|Financial Statements||Generally unnecessary for transactions under $150,000 (MD’s only)||Generally needed regardless of amount requested||Generally needed regardless of amount requested||None|
|Tax Benefits||Operating lease payments can be 100% tax deductible when shown as an operating expense||Depreciation can be taken over the useful life of the equipment||Depreciation can be taken over the useful life of the equipment||Depreciation can be taken over the useful life of the equipment|
|Equipment Obsolescence||Used as a hedge against obsolescence.||You own the equipment.||You own the equipment.||You own the equipment.|
Learn more about Smart Company Growth Equipment Finance here or click on the graphic below.