Operating Lease

Meaning of Operating Lease

An operating lease is a type of lease that allows one party, called as lessee; to use the asset owned by another, party called as lessor, in return to the rental payments for a particular period which is less than the assets economic rights and without transferring any rights in ownership at the end of the lease term.

It simply means a mechanism through which the owner of an asset or equipment ( officially termed as Lessor ) allows the user (officially termed as Lessee) to use an asset for a particular duration, which is shorter than the average economic life of the underlying asset. The LesseeThe LesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. read more is obliged to pay regular lease paymentsLease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration.read more or installments in return for a right to use an asset for an agreed period of time failing which the Lessor can take back the asset and contract stand void. An essential point of consideration is that there will not be any transfer of ownership. Such a contract is beneficial for both parties and provides them with unique opportunities to utilize their assets in the best possible way.

For LessorFor LessorA lessor is an individual who legally owns the asset granted on a lease (rented for a long tenure) to the lessee who pays a single lump sum amount or regular payments for using that asset.read more, it provides a mechanism to earn a fixed interest on an asset, which is otherwise not only giving any return but is also depreciating day by day. For Lessee, it provides a mechanism to utilize an asset or equipment without actually buying it. Operating lease through a fixed installment is less than purchasing the equipment from the market.

Example of an Operating Lease Contract

Let’s consider a firm ABC which operates in manufacturing auto parts, which are eventually supplied to the global automakers. To expand its business, our manufacturing firm needs more press machines. Let’s say the market price of each machine is $ 5,000,000, and the firm needs at least 2 such machines for its two production plants. The management does not want to invest significant capital until they are sure of the demand. In such a scenario, they can decide to lease the press machine for $ 5,000 a month. Hence the effective expense would be $ 10,000 per month for the firm ( taking both machines into account).

Such a mechanism will help the firm in fulfilling its strategic initiatives of expanding the manufacturing capacity at a much less amount without taking any business riskBusiness RiskBusiness risk is associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand.read more. What it has lost out to is the ownership rights, which at this moment of time is not the biggest issue that management is concerned about. Once the firm has tested waters and is confident of the available demand, they can go ahead and purchase the machines from the market.

Operating Lease

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Advantages

Disadvantages

Important Points to Note

Conclusion

Operating lease provides benefits to business, especially emerging firms that are cash strapped and do not have the luxury of available capital at demand. It provides a mechanism through which they can continue their business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation.read more through the services of the equipment or machinery without actually owning the underlying asset.

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