One of the central decisions a financial manager must make when acquiring business equipment is whether to lease the equipment or buy it (typically with loan financing). To make the best decision, I recommend you focus on three basic questions as part of your planning process:
- What are you acquiring?
- Why are you acquiring it?
- Given these circumstances, when would it make sense to lease vs. using equipment financing?
What Are You Acquiring?
Before you can determine what equipment financing structures are available, you have to do some capital expenditure planning. Start by identifying the assets you need to replace or acquire. What’s important here is that not all assets can be leased. Examples of assets that typically must be financed include:
- Limited-use assets. You can’t lease custom-developed equipment that can only be used by your business. If you don’t make your lease payments, your lessor will need to sell or lease the equipment to someone else. But limited use assets, such as custom-built equipment, often have no secondary market.
- Software. This is another type of asset a lessor would have issues leasing. Most software lease transactions are structured as conditional sales or $1 buyout leases — in other words, they’re loans disguised as leases.
- Assets with high ownership liability. Lessors have different risk tolerances, but there are certain asset types most will view as bad risks; either they won’t allow clients to lease them or they will charge a premium to do so. A good example is a fleet of school buses. Lessors know a school bus accident could lead to litigation targeting them as the bus owner, in addition to the lessee.
Before you start considering whether you would rather lease or buy equipment as part of your capex plan, determine if leasing is even an option.
Why Are You Acquiring It?
The lease-vs.-buy decision will also be impacted by your reason for acquiring the equipment. Most capital expenditures fall into one of three categories:
- Maintenance capex. This is core equipment you need to maintain the current operations of your business.
- Growth capex. Think of this category as equipment you would need if you landed your next big account.
- Speculative capex. This is equipment you acquire with the hope that it will enable you to land future business.
When Should You Lease vs. Finance?
Once you know what equipment you will be acquiring, and its purpose, you can start sorting through whether it will make more sense to finance or lease.
Every situation is different, but there are some general rules of thumb.
Financing typically makes more sense when you are acquiring core equipment you plan to keep for all of its useful life, and you can use the depreciation. If you lease, you run the risk of needing the equipment after the lease agreement has expired, requiring you to essentially acquire the equipment a second time.
Obviously, you will also need to finance any asset that isn’t lease-eligible.
Financing might also make sense for growth capex where you have the ability to fully utilize the depreciation and the business interest deductibility in year one.
Conversely, you might consider leasing core equipment if you are not tax efficient and cannot utilize depreciation fully in year one. In addition, leasing maintenance capex may be worth considering for cash flow reasons; a typical lease requires a lower cash outlay per year than debt of a similar term.
There are also situations where you might want to lease growth capex, such as when you land a contract for new business but the longevity of the business is uncertain or it’s for a relatively short period of time. For instance, if the contract is for three years, leasing the necessary equipment for three years would give you some financial flexibility.
As for speculative capex, banks generally will require such equipment to be purchased with free cash flow.
The decision-making process I’ve outlined in this article is fairly straightforward. However, there are many variables and financing options to consider. At Hancock Whitney, we can suggest alternatives for you to select from in consultation with your tax professionals. To learn more about Equipment Financing, contact us at 1-800-448-8812.
This information is educational and informational in nature, and not intended to be used as tax, legal or accounting advice. We advise you to consult your tax, legal and accounting advisors regarding your tax needs.