A CEO in one of our customer films said, “... one of the most important decisions management can make is what machinery and equipment they invest in because it stays with you for many years.” However, financing the machinery and equipment is not trivial because it influences the company's cash flow.

When a company acquires capital goods, it can finance them with cash payments, loans, or leasing. One could argue that if you can pay cash for an investment, then you do not have to worry about the profit margin; however, spending cash on investments without at least considering whether the cash was better spent on expansion into new segments or markets is not a good idea—this is what is referred to as the opportunity cost. This article lists the pros and cons of loan financing and leasing. 

Loan financing your assets
At a glance, loans can be obtained in several ways and with different profiles—we will not discuss the loan types. Still, they can have fixed or variable interest rates, and the loan profile can differ in the number of years, down payment, collateral, etc. 

Looking at the advantages of loan financing machinery and equipment, you typically own the asset outright once the loan is paid off. This means you can benefit from any appreciation in the asset's value. However, the asset rarely increases in value, but the so-called residual value can vary and has to be compared to the equivalent for leasing. Another advantage of loan financing is that you might have more flexibility in using the asset. You can customize it or modify it to suit your specific needs without restrictions imposed by the lender, as opposed to leasing, where the lessor can restrict the usage of machinery and equipment because they are interested in preserving the asset's resale value. 

Ultimately, deciding between a loan and leasing depends on factors such as the specific asset being financed, cash flow considerations, tax implications, and long-term strategic goals. It's essential to carefully evaluate the pros and cons of each option and consult with financial professionals to determine the best financing approach for your situation. 

However, they will all be listed on the balance sheet and, in this way, “crowd out” other assets. Those assets would, first and foremost, be customers. New customer segments or markets require capital because there is typically a customer acquisition cost and a credit cost for customers. 

Financial and operational leasing are two common methods businesses use to acquire assets, each with distinct characteristics and implications. Here are the key differences between financial and operational leasing: 

Ownership of the Asset 

Financial Lease: In a financial lease, the lessee (the business acquiring the asset) typically assumes most of the risks and benefits of ownership throughout the lease term. Although the lessor (the leasing company) retains legal ownership, the lessee often can purchase the asset at the end of the lease term for a predetermined amount, usually reflecting its residual value.

Operational Lease: In an operational lease, the lessor retains ownership of the leased asset throughout the lease period. The lessee primarily pays for the use of the asset during the lease term and typically returns it to the lessor at the end of the lease term, although there might be options for renewal or purchase at fair market value.

Term and Nature

Financial Lease: Financial leases usually cover a significant portion of an asset's useful life and are often structured as long-term agreements. They are typically used for acquiring essential assets akin to asset financing. 

Operational Lease: Operational leases are generally shorter-term agreements akin to renting. They are commonly used for assets with shorter useful lives or when the lessee wants to use them for a specific period without bearing the risks associated with ownership. 

Accounting Treatment

Financial Lease: Financial leases are often treated as capital leases for accounting purposes. Under accounting standards such as GAAP in the US or IFRS in Europe, the leased asset and corresponding liability are recorded on the lessee's balance sheet.

Operational Lease: Operational leases are typically treated as operating leases for accounting purposes. In this case, the leased asset and associated liability generally do not appear on the lessee's balance sheet, and lease payments are recognized as operating expenses on the income statement. 

Responsibilities and Risks

Financial Lease: In a financial lease, the lessee usually assumes responsibilities such as maintenance, insurance, and taxes associated with the leased asset, similar to those of an owner. 

Operational Lease: In an operational lease, the lessor typically retains responsibilities such as maintenance and insurance. The lessee primarily pays for the use of the asset and may have less responsibility for its upkeep than a financial lease. 

From a risk perspective, operational leasing does not load the lessee with the same risk, as the risk is carried by the asset owner, who sometimes passes this risk to the manufacturer. However, the risk is lower compared to loan financing. However, large customized installations are not offered on operational leasing terms. 

In summary, the choice between financial and operational leasing depends on factors such as the nature of the asset, the lessee's financial objectives, accounting treatment preferences, and the desired level of control, responsibility, and flexibility over the asset. Financial leasing is often used for long-term financing and ownership purposes, while operational leasing is favored for short-term needs and flexibility in asset usage. 

So, what are the pros of leasing

Conservation of Capital: Leasing allows your business to acquire necessary equipment upfront without tying up large amounts of capital. This can be particularly advantageous for businesses with limited capital resources or those wanting to preserve cash for other investments or operational needs - this could be cash for entering new markets or new customer segments. 

Fixed Payments: Lease agreements typically involve fixed monthly payments over the lease term. This makes budgeting and financial planning easier for businesses, as they know exactly how much they must pay each month, facilitating cash flow management.

Flexible Terms: Lease agreements often offer more flexibility regarding lease duration, end-of-lease options (such as purchasing the equipment at fair market value or extending the lease), and potential upgrades or add-ons during the lease term. This flexibility can benefit businesses with evolving needs or uncertain future requirements.

Maintenance and Support: Depending on the lease agreement, the lessor may be responsible for equipment maintenance and support, relieving the lessee of these responsibilities. This can save time and resources for the lessee, particularly with complex or specialized equipment requiring regular maintenance. 

Ease of Upgrading: Leasing allows businesses to easily upgrade to newer equipment at the end of the lease term without the hassle of selling or disposing of outdated equipment. This can be advantageous in industries where technology or equipment obsolescence is a concern.

Lower Initial Costs: Lease agreements often require minimal upfront costs compared to loan financing, which may involve down payments or other upfront expenses. This can make leasing more accessible for businesses with limited initial capital.

Losing capital equipment can provide businesses with greater financial flexibility, predictable costs, and potential tax benefits compared to loan financing. However, the suitability of leasing versus loan financing depends on various factors, including the specific needs and circumstances of the business, the nature of the equipment, and the terms and conditions of available financing options. 

Henrik Klem Lassen is the CEO of INKISH, and have a Masters's degree in Economics. and previously worked in companies like Deloitte and Coop, as well as the founder of several companies. He has also taught Economics and finance at ZIBAT and Copenhagen Business School.  

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