To conserve cash and for cash flow planning, when buying capital equipment, a business instead of paying outright using cash, it is usual to look for ways of spreading the cost of acquiring an asset, to coincide with the timing of the revenue generated by the business.

The most common sources of medium term finance for investment in capital assets are Hire Purchase and Leasing.

The basic similarity for these two facilities is that they allow a business to use an asset over a fixed period, in return for regular payments. The business customer chooses the equipment it requires and the finance company buys it on behalf of the business.

Business assets suitable for financing using hire purchase or leasing, includes Plant and machinery, motor vehicles, computers, office equipment and many others

For those who are not so familiar with these two sources of finance, this article provides:

• A basic understanding of the features/characteristics of hire purchase and leasing arrangement;

• situations where these facilities are conducive to be use as sources of finances and

• last but not least the advantages and disadvantages of leasing ( part 2)

Let’s look at Hire purchase Arrangement

• After all the installment payments have been made, the business customer becomes the owner of the equipment. This ownership transfer either automatically or on payment of an option to purchase fee;

• For tax purposes, from the beginning of the agreement the business customer is treated as the owner of the equipment and so can claim capital allowances. Don’t belittle the capital allowances as it is a significant tax incentives for businesses to invest in new plant and machinery or to upgrade information systems and

• Under a hire purchase agreement, the business customer is normally responsible for maintenance of the equipment

Leasing Facility:

• Ownership never passes to the business customer. Here, the leasing company claims the capital allowances and passes some of the benefit on to the business customer, by way of reduced rental charges;

• Generally, the full cost of lease rentals are deductible from taxable income, as a trading expense and

• As with hire purchase, the business customer will normally be responsible for maintenance of the equipment

Before we proceed further , we need to understand that basically there are a few type of leases which are as follows:

OPERATING LEASING:

• If a business needs a piece of equipment for a shorter time, then operating leasing may be the answer. Operating lease or service lease are short term contract. {This type of leasing is common for equipment where there is a well-established secondhand market like cars and construction equipment. The lease period will usually be for two to three years, although it may be much longer, but is always less than the working life of the machine.);

• Cancellable at the option of the lessee at a penalty;

• Lease period is less than the asset useful life. After the lease expires, the lessor can still lease out the asset to another lessee;

• Maintenance is the responsibility of the lessor;

• The leasing company will lease the equipment, expecting to sell it secondhand at the end of the lease, or to lease it again to someone else. It will, therefore, not need to recover the full cost of the equipment through the lease rentals.

• Assets financed under operating leases are not shown as assets on the balance sheet. Known as Off balance sheet financing. Instead, the entire operating lease cost is treated as a cost in the profit and loss

An example is Contract Hire which is a form of operating lease and it is often used for vehicles. The leasing company undertakes some responsibility for the management and maintenance of the vehicles. Services can include regular maintenance and repair costs, replacement of tyres and batteries, providing replacement vehicles, roadside assistance and recovery services and payment of the vehicle licences.

FINANCE LEASING:

• The finance lease or ‘full payout lease’ is closest to the hire purchase alternative. It is a long-term contract where the leasing company recovers the full cost of the equipment, plus charges, over the period of the lease;
• Therefore it is non-cancellable;
• Lease period # equal to the asset useful life which means that the asset cannot be lease out again at the end of the lease period;
• Maintenance and insuring the assets are the responsibility of the lessee;
• Fixed asset and lease payment discounted to present value must be shown in the balance sheet
• Although the business customer does not own the equipment, they have most of the ‘risks and rewards’ associated with ownership;
• When the lease period ends, the leasing company will usually agree to a secondary lease period at significantly reduced payments;
• Alternatively, if the business wishes to stop using the equipment, it may be sold second-hand to an unrelated third party. The business arranges the sale on behalf of the leasing company and obtains the bulk of the sale proceeds.

Incidentally, accounting standard dictates that in a finance lease is a lease that transfer substantially all the risk and rewards of ownership of an asset to the lessee.

Also, the present value of the minimum lease payment amounts to substantially all (90% or more) of the fair value of the asset. The present value should be calculated by using the implicit interest rate in the lease.

Like each financing mode needs to be considered in term of what a business requires hence, for both hire purchase and leasing arrangement, the following factors need to be considered:

One important advantage is that a hire purchase or leasing agreement is a medium term funding facility, which cannot be withdrawn, provided the business makes the payments as they fall due.

Certainty:

The uncertainty that may be associated with alternative funding facilities such as overdrafts, which are repayable on demand, is removed.

However, it should be borne in mind that both hire purchase and leasing agreements are long term commitments. It may not be possible, or could prove costly, to terminate them early.

Budgeting

For cash flow forecasting/planning, as hire purchase and/leasing have the distinct characteristic of regular fixed payment, it greatly help a business to forecast their cash requirement .The business is able to compare the payments with the expected revenue and profits generated by the use of the asset.

Fixed Rate Finance

As in both cases, the payments are fixed throughout the hire purchase or lease agreement, a business therefore is able to know right at the beginning of the agreement what their repayments will be. This can be beneficial in times of low, stable or rising interest rates but may appear expensive if interest rates are falling.

On some agreements, such as those for a longer term, the finance company may offer the option of variable rate agreements. In such cases, rentals or installments will vary with current interest rates; hence it may be more difficult to budget for the level of payment.

The Effect Of Security

Under both hire purchase and leasing, the finance company retains legal ownership of the equipment, at least until the end of the agreement. This normally gives the finance company better security than lenders of other types of loan or overdraft facilities. The finance company may therefore be able to offer better terms and to provide finance to even small or medium sized business .

Maximum Finance

Hire purchase and leasing could provide finance for the entire cost of the equipment. There may however, be a need to put down a deposit for hire purchase or to make one or more payments in advance under a lease. It may be possible for the business to ‘trade-in’ other assets which they own, as a means of raising the deposit.

Tax Advantages

Hire purchase and leasing give the business the choice of how to take advantage of capital allowances.

• For a profitable business,it can claim its own capital allowances through hire purchase or outright purchase whereas
• Loss making companies or companies about to make profit might consider leasing arrangement as it is more beneficial to the business. The leasing company will claim the capital allowances and pass the benefits on to the business by way of reduced rentals.

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Related Entries

• Hire Purchase, Credit Sales And Rental Agreement
• Internal And External Sources Of Finance
• Sale and Leaseback
• Accounting For Hire Purchase In The Purchaser’s Book
• Technical Summary Of IAS 17 Leases