to lease or to buy?
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Imagine that you are an owner of a small manufacturing business that assembles computer hardware. You put together products that need to withstand harsh conditions. In fact, you and your small team of developers have just developed a new hardware case that can withstand hurricanes, blizzards, and even intense heat without damaging delicate computing systems within. You feel that your innovation will be a hit, especially with the military. However, your company lacks the equipment to produce this new product on a grand scale. Your prototype has been handmade and would cost a fortune to make one by one. Investing in equipment is likely your next step, but how should you go about it?

Investing in equipment is a big issue with many small businesses. And it is usually financing the acquisitions that pose the biggest problem. Buying equipment means that your business assumes all of the risks and responsibilities of ownership. Loaning money for equipment means you not only place a depreciating asset on the balance sheet, but you gain a liability along with interest expense. A third option, leasing, allows you to place the risk of ownership upon another party, yet you likely will incur interest expenses in the agreement.

The following will discuss some of the advantages and disadvantages to both owning and leasing equipment. Through this discussion, it is hoped that you have a better understanding for what is best for your business when it comes to equipment acquisitions.

Ownership

Business ownership of equipment has its perks. When capital assets are on the balance sheet, you have the opportunity to save on taxes by using an accelerated depreciation method. This methodology allows businesses to defer taxes to a later period as higher depreciation expenses are incurred on the income statement prepared for the IRS as opposed to the company’s financial statements. Deferred taxes, moreover, have a lower present value in future periods than they do today due to inflation. In other words, $1 today will be worth less than $1 when you have to pay up. Therefore by deferring taxes, the government gets less purchasing power from your current tax dollar that your business put off to a future period.

Though this provides businesses with some cost savings there are two instances where this method cannot work. First of all, some companies in capital intensive industries are subject to the Alternative Minimum Tax, a law that limits depreciation benefits. Secondly, companies in the red will not benefit from the tax savings because they already have no taxable income to begin with. Companies such as these may be better off making a lease decision.

Companies practicing accelerated depreciation methods should also be sure that they are in compliance with current tax laws as well as GAAP standards of accounting.

Leasing

Leasing equipment has a major advantage over ownership. Overall, leasing allows companies to leverage their cash more efficiently. A company wishing to acquire a $10 million piece of equipment that has not enough cash and lacks borrowing power may choose to lease instead. This saves more cash for the company and keeps its debt to equity ratio as is. Leasing gives companies, especially small, the financial peace of mind they need to operate. Though companies will see rental expense hit the income statement, they will be able to acquire more net income since generally rent is less than combined interest and depreciation expenses from leveraged purchases. What is more, companies that lease incur no depreciation expense because their equipment is owned by another party.

Leasing “mission critical” equipment may be a bad idea for some companies. This is because companies using such equipment may not want to return it when the lease expires. Companies are then faced with the options to either purchase the equipment at fair market value or return the mission critical equipment. In the latter situation the company would then have to replace the equipment which can be time consuming and difficult to accomplish. Moreover, to purchase the equipment at fair market value at the end of the lease can be problematic. Often the fair market value of equipment at the end of a lease is more than a company is willing to pay for it. The company that leases equipment may therefore, be faced paying more at the end of the lease than they had originally intended. And because the equipment is mission critical, the company is almost stuck with buying it. In this case buying is a better alternative.

To lease or to buy are two options that most businesses will have to face. Buying can save money on taxes and leasing can lead to better overall profits. However, the right situation must be in place for either option. Leasing non-mission critical equipment, such as office equipment, is desirable because companies are able to easily replace them once leases have expired. Buying is advantageous if equipment will maintain resale value and if companies are not constrained by tax laws and income issues. Regardless, the decision to lease or buy will fit the company. Small companies generally lease to leverage cash flow and large companies will buy equipment to save money in the long term.