Which is better, leasing or buying expensive equipment or machinery for your business? Here are the factors you need to consider to determine the best option for your company.
If you’re buying expensive office electronics, lab equipment, heavy machinery or other items for your business, one of the first questions to ask is whether you should lease or buy what you need. If you have the cash, making an outright purchase is the simplest way to proceed, but could possibly lead to cash flow problems down the road. The other options – leasing the necessary equipment or taking out a purchase loan – spread the cost over a period of time but increase the total amount you pay for use of the equipment. There are distinct advantages to each system and different scenarios where one acquisition method should be favored over another.
Operating Lease vs. Capital Lease
There are two broad types of leases: True leases (called operating leases), through which you rent the equipment for a set period of time, and capital leases, through which you can acquire the equipment (often by making some additional payment) at the end of the lease term. The two types of leases are treated differently for tax purposes. With an operating lease you don’t own the equipment, so you deduct the leasing fee each month as a regular business expense. You are not entitled to any depreciation deductions. With a capital lease, the equipment is treated for tax purposes as though you have purchased it.
Generally speaking, leasing any given piece of equipment is more expensive than buying it outright. Despite this cost difference, there are many good reasons to lease. If the items you are considering purchasing run the risk of becoming obsolete before the end of their usable life, an operating lease could be a good option (provided the lease term isn’t longer than the expected useable life.) This is true for goods such as computers (when you need to acquire several at a time) or other electronics that rapidly become outdated. Signing a lease agreement means that at the end of the lease agreement you give back the equipment, and then buy or lease newer models. You won’t have the carrying costs associated with aging assets that may break down or need repair. (But if you still need the equipment, you’ll need to replace it, and transfer over any related items such as software, documents, store data, etc.)
There are also several financial incentives to an operating lease. Unlike a purchase loan, an operating lease agreement may require little or no down payment, conserving cash. The operating lease payments are written off as a business expense on your tax return, another benefit to leasing.
While these two monetary benefits can make leasing an attractive option, it is important to keep in mind the length of the lease term. If your business needs change suddenly and you need new or different equipment, you may be forced to pay hefty early termination fees to break your lease. As a general rule, if you plan to use the equipment for five years or less and there is a good chance of obsolescence, an operating lease may be a good choice.
Pros and Cons of Purchasing Equipment
If, however, you plan on using your equipment for over five years, and it holds its value well, then you should consider purchasing it using either a capital lease or a bank loan. Purchasing equipment also allows the owner to customize it, and easily sell or trade it (after it’s paid for) if the business’s needs change. With either a capital lease or a loan, you will be liable for all payments. Your accountant should be able to help you determine whether a bank loan or a capital lease is the best option for your needs.
When taking a loan to purchase equipment, a downpayment may be required, and the upfront costs may be higher than leasing. However, the lifetime cost of the equipment may be lower than when the same item is leased. Furthermore, you won’t be forced to give up the equipment on a predetermined date.
While buying equipment is cheaper in the long term and offers the benefits of flexibility and captured equity, there are some risks associated with the outright purchase of equipment. Namely, if the equipment suddenly becomes obsolete and needs to be replaced, or the land or other assets you purchased decline in value, you may be left in a position where you owe more on the loan than the asset is worth.
Buying and leasing business equipment offer both costs and benefits. Cash flow is a major consideration, as well as the expected length of use, and the tax implications of a purchase or lease. Your business should determine the cost-effectiveness of both approaches, and proceed with the option that best fits your needs and cash on hand. Talk to your accountant before you make any decisions and let him or her advise you based on your business finances and the tax implications of leasing vs purchasing the equipment.