Plants require fuel for growth, and a business is no different. Companies grow by synthesizing assets — people, equipment, and property — to deliver goods and services. It is typically easy to tell by looking at a plant if it is getting the right nutrition. An important gauge of a business’ health is the balance sheet, which indicates how efficiently the company uses its assets. It also supports decisions by lenders, sureties, and investors about whether to seed the business with capital assets.
Operating leases have long been especially attractive because the leased assets and obligations did not appear on the balance sheet. Consequently, businesses had greater credit capacity for other types of financing, such as working capital loans. That benefit went away with the final release of the new lease accounting standard. The requirement to report leased assets and liabilities on balance sheets will change the financial ratios that lenders and other underwriters use to make their financing decisions.
Food for Thought: Advantages of Leased vs. Purchased Assets
Companies that employed leasing primarily as a way to carry less debt on the balance sheet may be asking a reasonable question: “Should we continue to lease?” If the sole motivation to lease is the ability to keep assets and liabilities off the balance sheet, then the short answer to that question most likely is, “No.” However, as with many important decisions, the choice of financing option involves a number of nuances. Consider the following five questions.
- Would lenders and other financial statement users accept a GAAP departure? In some cases, lenders and other users of private company financial statement users are willing (or would prefer) that the companies they underwrite continue to report leases as they always have. Before deciding how to move forward, businesses should discuss the new standard’s potential effects on financial ratios — as well as the implementation costs and resource implications — with lenders and other financial statements users. Depending on the outcome of these negotiations, leasing assets could remain as attractive a growth strategy as ever.
- What is the current credit rating? Companies that have built up strong credit might be able to qualify for lower interest rates through traditional sources of financing — making a purchase the more cost-effective strategy. For companies with less favorable credit ratings, leasing might be the most expedient way to finance critical assets such as office space, operating equipment, or fleet vehicles. Especially in the start-up phase, businesses typically have not yet established the credit they need to qualify for traditional loans.
“Leasing companies typically accept a somewhat higher degree of credit risk because they look to the value of the equipment for collateral if [the] business cannot make the agreed-upon payments.” – CRI’s Start-Up Business Guide: Your Itinerary for Success. Download your copy.
- Is cash available for a down payment? For businesses that can afford a sizeable down payment on a traditional loan, the total cost of financing a purchase often can be less than the cost of financing over an entire lease term. For new companies, however, expenses are likely to outstrip available cash. Businesses that want to make more cash flow available may choose to lease since the upfront and monthly cash requirements often are lower.
- How important is it to have the latest and greatest? When it comes to technology that is likely to be obsolete within a few years, the flexibility of leasing is most often an advantage. If a company’s competitive edge depends on access to the most up-to-date technology, then leasing can be a simpler and less expensive alternative to buying the technology and selling it when it is no longer needed. Business leaders concerned about obsolescence should find out whether the lease contract includes upgrades as they become available.
- Is customization necessary? Leasing companies generally prefer to finance equipment that serves a general purpose. In doing so, they can re-lease or sell the equipment at the end of the term. Specialty manufacturers and other businesses with custom requirements might not be able to obtain those modifications through a lease. Instead, they might need to purchase their equipment or production facilities.
Let CRI Help You Tend Your Blooming Business
Nurturing a business requires making many decisions, and the choice of whether to purchase or lease assets is just one of them. For entities with significant lease commitments, the new lease accounting standard will likely have a dramatic effect on their accounting resources and balance sheets going forward.
Our CPAs and advisors stand ready with guidance about the proper use of resources and the decision of whether to lease or buy assets – as well as accounting support to meet reporting requirements. Please contact us if you have questions regarding how the new lease standard will affect your business’ growth strategies.