Lease vs. Buy Decision

December 2006

Should we lease that fixed asset or should we buy it? There are MANY factors to consider—so many that the choice can be hard to make. It is worth sitting down and asking yourself some key questions. If you want to give this self-examination a fancy title, you can call it a “financial and strategic analysis.” Some questions you may want to consider are listed below.

Your lender and/or the company you are leasing equipment or fixed assets from should be able to help you in the analysis. (Of course, they may skew the analysis a bit in their favor!)

A lease is an expense; a purchase is capitalized and depreciated

For accounting purposes, a lease is treated as an expense: each lease payment flows through the income statement, reducing profit by the amount of the lease payment. This in turn reduces retained earnings on the balance sheet. So you realize an expense each time you make a lease payment. You do not record the thing you are leasing as an asset on the balance sheet. Cash is reduced slowly—in little drips—over the life of the lease.

If you purchase an item, it is recorded as a fixed asset on the balance sheet and depreciated over the useful life of the asset. Depreciation recognizes an expense for the use of an asset over the life of the asset. Depending on the useful life of the asset, you may be expensing the cost of the asset more slowly if you capitalize it (capitalize in this instance means “purchase and record as a fixed asset”) than if you lease and expense it. If you finance the purchase, cash will flow out at the rate of your principle and interest payments. If you buy the item outright, you will pay the full price for it—in cash—immediately.

Who owns the item?

One of the benefits of leasing is that you do not own the old used equipment and have to dispose of it when you are finished using it. One of the key downsides to leasing is that you don’t own the equipment even though you may have paid the full purchase price for it over time, so any value the item has reverts to the lessor.

Some questions to ponder

Here are some questions you need to ask before you can decide whether to lease or buy:

What effect will a lease or a purchase have on cash flow?

• Is a down payment required? Generally leases don’t require a down payment; purchases do.
  
  
• At the end of the lease, do you have the right to sell the asset and earn some cash? In general, at the end of a lease you don’t own the fixed asset; it reverts to the lessor. If you purchased the fixed asset, you may be able to realize a nice chunk of cash flow somewhere down the line when you sell it. Some leases allow the lessee to pay a chunk of cash at the end of the lease to own it outright. (Be careful with these arrangements, because accounting standards and IRS rules may consider such arrangements to be substantially a purchase and not a lease.)
  
  
• Are you going to pay cash for the fixed asset now or finance it over time?
  
  
• What is the effect on cash flow for each monthly payment, whether it be on the loan you used to purchase the fixed asset or on the lease?

What effect will the lease or purchase have on income?

• How fast will expenses be realized on each option? Under a lease, the entire payment is recorded on the income statement and reduces income. Under a purchase, the only expense realized is depreciation expense. How long is the useful life and how quickly will you realize the depreciation expense on the income statement?
  
  
• What effect will each option have on taxes? That depends on your answer to the above question.

What effect will the lease or purchase have on the balance sheet?

• Will putting the asset on the balance sheet “bust the covenants” of a loan or skew key financial metrics? Do you have an outstanding loan that has restrictions on how much more debt you can incur or how much you can have recorded as fixed assets? Do your investors have expectations about your fixed asset balance and accumulated depreciation balance that would be negatively impacted by a purchase?
  
  
• Will leasing the item be misleading to investors? Would disclosing it on the balance sheet as something the business needs to operate be a more realistic and reasonable representation of reality?

Will a lease make the reality that we eventually have to replace equipment more palatable to shareholders and decision makers?

And don’t forget the time value of money. The time value of money concept reminds us that $1 today is worth more than $1 in five years, because we could have invested the $1 and made some interest income from it. So the timing of cash inflows and outflows will have an impact on your decision.

An excellent article

There is an excellent article in the July 2005 edition of CFO Magazine about the dangers of leasing that is worth a look. See http://www.cfo.com/article.cfm/7108979?f=search