10 minutes on lease contracts

Every manager will have been confronted with the terms lease, whether operational or financial, as opposed to ownership. Also ‘sale & lease back’ is a term which pops up regularly. I will touch on the individual definition of each one of these very briefly (other resources on the internet do a far better job at this), whereby the emphasis is on the practical understanding rather than every legal detail. Then I will compare one with the other, comparing the financial impact the different options have on your cash and profit.

This article grew from a personal frustration some years ago where I discovered that ‘lease’ is one of those terms that everybody knows and uses without necessarily having a full understanding of it. Like usual, my aim is to bring enlightenment in less than 10 minutes.

Ownership

Obviously the most basic of relation a company can have with an asset. A company can own land, buildings, cars or other types of assets. It can own goodwill and intellectual property (immaterial assets). The company will have mostly bought it, hence it will have done a large, upfront, single payment to obtain it. As a basic principle in corporate finance is to book costs through the same period as the benefits are earned, a company will not book the acquisition of an asset in one period for the full amount. It will spread the cost over the assumed lifetime, and call it depreciation. International accounting standards determine for most assets how long this ‘assumed lifetime’ is.

Therefore, buying an asset will lead to a serious discrepancy between cash flow and profit.

Generally, it is considered not a good idea for a company to buy all assets. It requires humongous amounts of cash upfront and means a significant risk to earn back the benefits in time. Also, in any ‘return on assets’ or ‘return on investment’ calculation (more about this later), the denominator is so big it will pull the ratio down significantly.

Lease

Enter lease. Ok most companies have figured out that they rather not pay many millions in the first year of their existence with a vague promise to earn this back in a decade. The company (lessee) are willing to pay a small premium to someone else to hold the assets (this is the owner, e.g. a bank, called the lessor) and to give them only the use of it over a specific period of time. The main benefits will be:

  1. capital efficiency: a company does not have to cough up the investment itself
  2. in case of operational lease: no impact on RoA / RoI
  3. risk of obsolescence: is the owner’s and not the company’s
  4. tax benefits: lease payments come in a deductible costs
  5. easier than obtaining a loan

 

Financial Lease (= Capital lease)

This lease construction allows the company (lessee) to have economic ownership of an asset it selected and for which they pay regular fees. The lessor has bought the asset for them. There is a possibility for the company to acquire the asset at the end of the lease term (which will be close to the economic life of the asset) for a small payment. The regular fees will by then have amounted to roughly the initial investment done (and the interest).

Since this is leading to ownership at the end of the term, financial leases are ‘capitalised’ which means that the asset (and the liability) will show up in the balance sheet of the company, thereby influencing RoA, RoI and working capital.

Operating Lease

An operating lease entails that the lessee will lease the asset for a period shorter that the asset’s economic life. The lessor, retaining ownership at all times, expects to have a significant value of his asset after the lease ended and can expect to re-lease it to the next party. The lessee does not have the option to buy the asset at the end of the contract. As there will be no ownership, the asset does not end up on the balance sheet. RoI and RoA will be artificially high. This is also called ‘off balance leases’.

Difference between Financial and Operational Lease

  Financial lease Operating lease
Lease term about economic lifetime of asset shorter than lifetime
Ownership opportunity to buy at the end no such opportunity
Risks of obsol, maintenance for lessee for lessor
Balance impact on balance off balance

 Sale and Lease back

 So significant are the benefits for a company, that there is a trend to sell the assets they historically owned and lease them back. The main reason for this is to free up great amounts of cash, which in turn can be put to better use.

Long story short

Have a look at these 2 graphs. Let’s take an example of a company which needs equipment worth 600K, depreciated in 3 years.

The cash requirement when opting for the ownership is very high the first year, like shown on the first graph below.  The impact on the profit line for that same company will then look like the second graph below. The depreciation is 200K a year and leasing will be more expensive because of the interest charged.

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About curiousmanager

In life there are generalists and specialists. Although your job pushes you down towards a certain specialization, I feel it's important to keep your eyes and mind open for new stimuli. And I want to share my journey through arts, literature and sciences with other knowledge workers and managers. You don't have time to read. Let me do that for you and present only the best of the best in my blog!
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2 Responses to 10 minutes on lease contracts

  1. Pingback: How to read any Balance Sheet | The Curious Manager

  2. Pingback: How to read any Balance Sheet | The Curious Manager

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