Distinguish Between Finance Lease and Operating Lease

A lease is a financial agreement between two parties wherein the user of the asset (called the lessee) pays the owner of the asset (called the lessor) for using the asset for a pre-defined period. However, leasing is broadly divided into two categories, finance lease and operating lease. Read on to have an in-depth look at these categories and find out the differences between finance lease vs operating lease.

What is a Finance Lease (Meaning)?

Finance Lease can be referred to as a type of lease where the lessee (user) only has operating control over an asset, as per the agreement’s tenure. At the end of the lease period, the lessee (user) becomes the asset owner by paying a certain amount. In short, in the case of a finance lease, the asset’s acquisition cost is spread over the life of the lease. Over the lease period, the financial risks and rewards will be shared by both parties in varying degrees as per the lease agreement.
In the case of a finance lease, the customer (user) zeroes in on the desired asset. The finance company then purchases the asset, including the cost of the asset and interest. The customer starts paying a fixed amount periodically (mostly monthly) to the leasing company for using the asset. Once the lease period is over and all payments have been made, the user has the option to buy (take ownership of) the asset.

Advantages and Disadvantages of Finance Lease 

Below you will find the different benefits and drawbacks associated with finance leasing. 

Advantages of Finance Lease

There are several advantages of a finance lease, which you can learn about in the following points:

• The owner (lessor) gets tax benefits for income suppression on account of depreciation.
• Similarly, the user (lessee) can claim tax benefits by deducting tax payments as expenses.
• The lessor is also guaranteed a steady income by way of monthly rental payments received from the user (lessee).
• The user (lessee) is protected against inflation, since the price of an asset for the lessee remains unchanged throughout the lease period, irrespective of inflationary effects in the economy. 

Disadvantages of Finance Lease 

The list of points below will explain the major disadvantages of financial leasing:

• These lease agreements cannot be cancelled. Thus even if you don’t use the asset, you have to pay for it as per the agreement.
• You do not own a leased asset, even if you like the asset and decide to buy it. A lessor will only decide if he wants to sell it or not.
• You will be responsible for paying all the expenses related to the asset, despite not owning it. 

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What is an Operating Lease (Meaning)?

An Operating Lease is one in which the user (lessee) uses the asset for the lease period, but does not, in any way, assume ownership rights of the asset. Thus, the user incurs relatively lower expenses for using the asset but does not incur heavy expenses needed for buying the same. Since the user (lessee) does not intend to buy the asset, it is not shown on the lessee’s balance sheet, thereby allowing for a leaner balance sheet and a lower debt-equity ratio. As a result, an operating lease is considered to be off-balance sheet financing. 

Advantages and Disadvantages of Operating Lease

Below you will learn about the different benefits and drawbacks of an operating lease, respectively. 

Advantages of Operating Lease

There are several advantages of an operating lease such as:

• Since the borrower is not looking to own the asset, the financial consideration for the lessee is lower. This is good for businesses that are smaller in size or those that are looking to lease the asset for a short period.
• The lessee does not have to pay for repairs and maintenance of the asset.
• If you fear that technological advances could make your equipment obsolete within a few years, an operating lease provides you with a great way to use the equipment for a limited period and then switch it.
• Payments made towards servicing the asset can be deducted as operating expenses for tax calculation.

Disadvantages of Operating Lease

Below you can find the different disadvantages of an operating lease:

• When someone takes a lease, they don’t get any equity. Thus, they don’t have any decision-making rights.
• While financing your lease you will incur interest. This means you have to pay financing costs even without having any equity.
• If you lease an asset for a long period, the total leasing cost might be more than its market value when compared to the initial stage, when the lease agreement was first done.
• Short-term leases can create various issues, and continuous negotiation of terms can create problems. This is because owners would be able to get an opportunity to increase the fees every time.

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Finance Lease VS Operating Lease

Below are some of the notable differences between finance lease and operating lease:   

Which Type of Lease is Best for You?

The type of lease to be used depends on factors such as the type of business, the operating environment, the financial condition of the business, etc. There is no simple answer to this question, and it depends on a host of factors. 
If you wish to own an asset but without the burden of high upfront payment, you can go in for a finance lease. On the other hand, if you just need to use the asset for a short time without getting into the hassle of ownership, you can go in for an operating lease.
With ownership comes the hassle of repairs and maintenance of the asset. In an operating lease, you are just leasing the asset for your use, hence you do not have to get into the repairs and maintenance that is handled by the lessor. If you are looking at having a leaner balance sheet, an operating lease might suit you.
Hence, it is clear that the type of lease you need to enter depends on your requirements. It differs from business to business and circumstance to circumstance. Another option for leasing is buying, which involves an upfront payment to acquire the asset. 

To Conclude

Whether you buy or lease something, always make sure that you use your financial resources wisely to not get into any trouble. The finance lease vs operating lease section will help you understand the process of leasing and decide which category serves you better. If you have any funding requirements for leasing, you can always borrow funds through a Personal Loan.
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Frequently Asked Questions About Finance & Operating lease

1.    What is a finance lease with an example?
A finance lease is one in which the user assumes operating control of the asset during the term of the lease and ownership of the asset at the end of the lease period.
Example – The estimated useful life of machinery is 5 years, and the lease period is 4 years. At current valuations, the fair value of the machinery is Rs.10 Crore, while the present value of lease payments is Rs.9.5 Crore. This is an example of a finance lease because it satisfies both the conditions of a finance lease. Firstly, the lease period is at least 75% of the estimated useful life of the machinery (4/5 = 80%). Secondly, the present value of lease payments is at least 90% of the fair value of the machinery (9.5 / 10 = 95%).
2.    Which is better: finance or operating lease?
There is no “better” type of lease. The type of lease you need to use depends on your requirements, financial position, and the time for which you need the asset, and so on. Both operating and finance lease have their advantages under specific circumstances. 
3.    Are capital leases now called finance leases?
Capital leases and finance leases are both terms used interchangeably.