Finance Lease vs. Operating Lease: Which One Should You Choose?

Equipment financing can be challenging when you’re running a small business. Your starting capital may not be enough to get the assets you need to outdo your competition. Seeking financing solutions to buy what your business needs can also be difficult, and complex. Fortunately, you have the option to lease instead of buy immediately.

Two of your options are finance leases and operating leases. But what’s the difference between the two?

What is a Financial Lease?

Also known as a capital lease, a financial lease involves creating a contract that entitles a business owner to rent out the temporary use of an asset, mostly equipment. This is usually done over a long period of time.

Pros

• For accounting purposes, this lease is considered a purchase of an asset for you as a business owner. So you own it on paper, even though you still haven’t paid for it fully.
• You take the present market value of your asset on your balance sheet. As such, you’re allowed to claim depreciation and reduce your taxable income.
• You can reduce your taxable income further by claiming interest expense.

The advantages of a financial lease work to reduce your business taxes, and you get to own the equipment you’re paying for all these months. However, it does come with some disadvantages.

Cons

• A capital lease agreement is classified as debt in your balance sheet. You repay through your lease payments. This increases your debt to equity ratio. Having your company operate more on debt than your wholly-owned funds might scare off your investors, as they may see it as a risky way of operating your business.
• Another potential disadvantage of the finance lease is that your company has full responsibility for the maintenance of the equipment.
• You’re also stuck with the pieces of equipment you rent out for the rest of your leasing term. If you’re using electronic tools, like computers, its components may be obsolete within a decade or even just a few years, leaving you at a competitive disadvantage.

What is an Operating Lease?

An operating lease allows you to rent out equipment from a lessee, but unlike a capital lease, you don’t have ownership rights to the asset. This type of lease isn’t included in the company balance sheet as well. At the end of your payment term, you can choose to buy the equipment at market value or return them to your lessor.

This type of lease is often short-term.

Pros

• Gives you greater flexibility since it’s a short-term lease. If the equipment in your industry tends to become obsolete faster than other industries, an operating lease allows you to upgrade without the big cost.
• Its tax benefits allow you to deduct the payments you make as an operating expense.
• Because you’re not renting to own an asset, you’ll generally have to pay less for your monthly payments, compared to capital leasing.

An operating lease is ideal if you’re a business that needs regular upgrades to your equipment. However, it also comes with some downsides.

Cons

• Because this type of lease allows you to upgrade whenever possible, you may find that you pay more for your equipment in the long run.
• Although you can deduct your operating lease payments for your tax returns, you still don’t own the asset. As such, you may not be able to claim deductions for the depreciation of your equipment, unlike capital leasing.

Which Lease is the Best Option for Your Business?

Asset acquisition through leases is a practical way to run your business at a manageable cost. But consider your options carefully because finance and operating leases can be complex without factoring in your requirements and tax situation.

Consult with a Regent Capital consultant to ensure you’re getting one that’s favorable for your business.

Regent Capital is a trusted commercial finance company. We turn your real-world financing challenges into success stories and results. Call us today at (888) 901-4207 for details on how we can help your business!