There is a common perception—particularly for IT equipment—that leasing is an easier, more efficient and more cost-effective way to procure equipment than using commercial business loans or other forms of debt to purchase the equipment.
There are several reasons for this view:
- If risk is properly capped in lease agreements, leasing can generally allow an enterprise to pay only about 90% of the original equipment cost (OEC) and then return the equipment, when it has relatively little, if any, useful life left. This is seen as a way to avoid the cost of technical obsolescence.
- Many CFOs prefer to preserve their enterprise’s commercial lines of credit for needs that they deem more business-critical.
- Using commercial lines of credit can put an enterprise out of compliance with bank covenants.
- Leases classified under current U.S. accounting rules as operating leases can be kept off the balance sheet, improving key financial metrics.
Commercial Business Loans: No Strings Attached
It’s true that equipment leasing companies will generally offer lower lease rates than the interest rate received on commercial business loans. But a lease rate is not the same as the interest rate from a bank. To determine the actual financing cost of a lease, an enterprise must look at all costs associated with the lease—fees, penalties, interim rent, lease extensions, buyout cost, etc.
When evaluated in this manner—with full financial analysis as opposed to a simple comparison of lease rate vs. interest rate—commercial business loans become much more appealing. Enterprises are often enticed by the opportunity to lower equipment costs by entering into low-rate leases and successfully managing the high risk that lease agreements contain — but if an enterprise fails at this effort, the result could be disastrous. It’s not uncommon for enterprises that lease equipment without controlling risk to pay as much as two times as much for equipment as the original equipment cost (OEC).
Commercial business loans, on the other hand, are generally “no surprises” transactions. Risk is virtually nonexistent—the interest rate is the cost, and that’s it. And commercial business loans provide a critically important additional benefit—the enterprise has control over its equipment refresh schedule, keeping it from losing leverage by being tied to a lessor’s lease schedule.
Making a Choice
So the crux of the decision between commercial business loans and equipment leases is the capability of the enterprise to adequately identify and control risk in lease negotiations and operations. Enterprises need to realistically assess their aptitude at negotiating to reduce risk in lease agreements and seek expert assistance if needed. Assumptions about returning equipment and achieving other operational goals (e.g., meeting notices, paying on time) should be measured against the historical record to determine how realistic they are.
The situation in equipment leasing today is that unless a lessee works with an expert to cap risk and cost of leasing most enterprises will find commercial business loans more cost-effective. Unless an enterprise is very well-prepared in terms of leasing agreement expertise and operational capabilities to actually achieve the cost savings promised by equipment leasing leasing will be the higher cost alternative.
Conclusion
Failing to understand and give appropriate weight to the risks of equipment leasing can have dire consequences. When risks aren’t capped in lease agreements and managed during operations, enterprises often end up paying multiple times as much for equipment than if they had financed the equipment through a commercial loan.
Enterprises that want to pursue the cost savings possible with equipment leasing can be successful with this strategy—but only if they are well-armed with knowledge about the substantial risks involved and how to minimize them.
