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 Lessee is obliged to pay regular lease payments 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 Lessor, 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).
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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 risk. 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.
- Equipment Required for Short Duration – This lease makes sense when the equipment in consideration is not required for the longer-term. The management can lease the equipment at a fraction of the amount and use the remaining amount to generate more profitable opportunities.
- Equipment might become Obsolete – It is beneficial when there is a risk of equipment becoming outdated in the near future. Especially in industries undergoing disruption, this risk is amplified much more and can threaten the profitability of the firm. It is the reason why many technology firms are going for PAAS – platform as a service and IAAS – Infrastructure as a service or Cloud services offered by tech giants like Amazon and Microsoft. Firms can safeguard themselves by paying a small amount from any such disruption in these areas as any such risk will be borne by these tech giants.
- Tight Cash Flow – A firm going through the times of distress can opt for operating lease as this will help it in continuing with its daily operating activities without putting a lot of its capital at risk.
- Tax Benefits – This lease provides tax benefits. The lease expenses can be deducted from the operating expenses during the payment period. Needless to say, such tax benefits can remove any constraint on the firm’s cash flows leading to better financial health.
- Finance Cost – This lease has a financing cost associated with it. There is a rate of interest embedded in the contract which the firm must accept even though it might look like a bit above the prevailing market rate. Such a mechanism puts the firm at an interest rate risk and might question the management strategy aimed at leasing rather than going for purchasing the equipment.
- Reduced return for equity holders – In the leasing contract, the firm does not own the equipment. Had it been owned, it would have been an asset, but in operating lease terms, it is realized as a liability on the financial statements. It leads to a reduced return on equity for shareholders.
Important Points to Note
- Operating lease is recorded as off-balance sheet items, which effectively means that the underlying asset and any liabilities related to it like rent payments or any installments in the future are not recorded on the Lessee’s balance sheet statement. It allows firms to keep debt to equity ratio low and in permissible limits avoiding any red flags from both equity holders and debt holders.
Historically effective utilization of such a lease has helped global firms to hold billions of dollars of assets and liabilities without recording them on the balance sheets. However, as per the new rule, all operating leases more than 12 months should be recorded in the balance sheet appropriately by the public companies.
- For an operating lease to be effectively framed and avoid any wrath from regulators, it is necessary that it is well-differentiated from a capital lease. It effectively means that there should not be an ownership transfer at the end of the agreed time period, and the lease contract duration should not be more than 75% of the economic life of the underlying asset.
Some lease contracts also make sure that the present value of the installment payments should not exceed 90% of the equipment’s current market value, and the contract should be free from any bargain purchase option.
- Typically, all types of assets and equipment can be rented as an operating lease. E.g., of aircraft, machinery, land or real estate, or some business-specific equipment.
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 operations through the services of the equipment or machinery without actually owning the underlying asset.
This article has been a guide to Operating Lease definition and its meaning. Here we discuss how operating lease works along with examples, advantages, and disadvantages. You can learn more about the financing from the following articles –