The pros and cons of Asset Finance
This article outlines both the real benefits of asset finance as well as the many additional considerations that must be made in order to make an informed financial decision about acquiring assets.
Most businesses need to use a variety of assets in order to provide a service or manufacture a product for their customers.
Assets range from equipment assets like computer systems, photocopiers, office furniture, restaurant equipment, plant, machinery to vehicle assets like commercial vehicles, company cars, forklift trucks and buses.
Paying for assets outright with cash can place a strain on the working capital position of a business. It can also reduce the future opportunities a business has to raise funds for growth.
Asset Financing is about the alternative financial methods that can be used to acquire or rent business assets without using up valuable working capital.
Also worth noting is that some businesses acquire assets without being fully aware of the impact the financing method they choose has on their cash-flow, tax and VAT liability, credit status, bank exposure (especially during times of lean trading) and available funds for growth.
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Asset Finance Options
There are three main ways to finance an asset:
- Purchase outright with cash, bank loan or overdraft
- Hire/Contract purchase
- Leasing.
There are both advantages and disadvantages of each option:
PURCHASE OUTRIGHT:
Advantages of purchase
- You own the asset and it can't be repossessed - unless it has been used as security for a loan
- As the owner of the asset from a tax perspective you can claim your own capital allowances
- You’re not tied into potentially inflexible medium or long-term agreements which may be difficult to terminate
- Your business does not have to be VAT registered.
Disadvantages of purchase
- You pay the full cost of the asset up front out of working capital, or debt finance, which adds to the cost
- A small company will have limited bargaining power and knowledge with regards to the potential discounts available
- A small business is gambling that it will not need the capital for the medium and long-term
- The cost cannot be spread to coincide with money coming in to the business
- You are responsible for the maintenance and servicing of the asset
- Banks can withdraw overdrafts and loans at short notice and demand early repayment
- You are unable to take advantage of the tax benefits of deducting the cost of rental from your taxable income
- It may take longer to source and administer the purchase
- All the risk is taken by you.
LEASING:
Advantages of leasing
- Avoid having to pay the full cost of the asset up front, so you don’t use up your working capital or have to borrow
- Only pay for the asset over the fixed period of time that it is needed by you
- Easier to forecast cashflow as rates on monthly rental costs are usually fixed
- The cost can be more easily be planned to coincide with revenue coming into the business
- Reduce your tax bill by deducting the full cost of lease rentals from taxable income
- For companies that either do not pay tax or pay at the small company rate, the 100% tax allowances of lease rental are normally more beneficial than capital allowances for outright purchase options
- No need to worry about an overdraft or other loan being withdrawn at short notice due to changes in bank policy or personnel
- Maintenance and other asset management service items can be written into operating lease or contract hire contracts
- The risk is carried by the leasing company
- The leasing company can usually obtain better discounts due to their greater purchasing power.
Disadvantages of leasing:
- Your business may be locked into a medium or long term contract which may be difficult to terminate
- Leasing can be more complex to understand than buying outright
- Businesses normally have to be VAT-registered to take out a leasing agreement
- You don’t own the asset, except eventually in the case of hire-purchase.
As well as a variety of ways of acquiring an asset there are several different types of asset finance. There are many similarities as well as distinct differences and your ultimate choice must take into consideration your very specific criteria.
Asset Finance Types:
Operating Lease
The asset belongs to the lessor who effectively rents the asset to you the lessee over an agreed period (usually one to five years). Since the lessor will either sell the asset in the second hand market or lease it again at the end of the agreed term the lease payments can be kept low because the full asset value does not need to be recovered by the lessor during the first term. At the end of the leasing period the asset is either returned to the lessor or a further leasing agreement may be negotiated (only at the end of the initial term).
Contract Hire
Is another form of operating lease (often used with vehicles) which includes many potential service features like maintenance, replacement during repair, management, etc. again the lessor owns the asset.
The rental calculation is based on a residual value of the asset over a predetermined period and so includes a fee to cover for depreciation over the hire period.
Finance Lease
Again the asset is owned by the lessor only this time the leasing payments are calculated to include the full cost of owning the asset. Alternatively a balloon payment may be included to keep repayments low. When the asset is sold at the end of the term the lessee will share a percentage of the disposal price with the leasing company. There may be an option to extend the rental period at the end of the term for a “peppercorn” rent.
Contract/Hire Purchase
Contract purchase is the commercial equivalent of hire purchase. The asset is owned by the “hiring” company until the final payment is made at the end of the term.
Lease Purchase
Lease purchase is technically impossible since lease means rental not purchase. Lease purchase is essentially a hire purchase contract with a single larger payment at the end of the term. Once the final payment is made then legal title to ownership is transferred to the purchaser.
Leasing versus Purchase (Further comparisons and considerations)
As mentioned earlier there are key differences between leasing and purchasing assets.
Below are a selection of the additional considerations:
Tax
Leasing (Operating, Contract Hire and Finance) contract repayments are 100% fully tax allowable unlike outright purchase options where only the capital allowances can be claimed against tax.
If the purchase was made via a Lease/Contract Purchase or with a bank loan then the interest charges can also be reclaimed against tax.
Cash-flow
Leasing preserves the working capital of a business and is also tax efficient. It enables businesses to use their working capital to invest for growth or in assets that have the potential to appreciate. Outright purchase options use up available funds and are not as tax efficient. Lease/Contract Purchase options also preserve working capital but are not as tax efficient compared to Operating and Finance Leasing options.
Credit and debt status
Operating Lease and Contract Hire options preserve the credit status of a business as these lease payments are normally classified as an expense and not debt -operating leases and Contract Hire arrangements are regarded as “off balance sheet”. This therefore preserves the flexibility to utilise any further debt facility (from the bank/specialist lender) for other more growth focused requirements.
Balance sheet
If an asset is purchased (outright or with Lease purchase) or acquired using a Finance Lease then it will show on the balance sheet since it is ultimately owned by you. However Operating Leases and Contract Hire options keep assets acquired in this way off the balance sheet thereby further protecting your credit status.
VAT
With all the purchase options VAT is payable up front whereas with Operating and Finance Leases VAT is payable over the term of the lease thereby further protecting cash-flow.
Exposure to obsolete technology
Leasing options which enable the lessee to hand back the asset at the end of the agreed term help the lessee to benefit straight away from improvements in new technology associated with the particular asset. However if the asset has been purchased outright there is the challenge of finding a buyer for the older asset before a new purchase can be made.
Frequently asked questions:
Q. Why should I lease assets when I could buy them outright?
A. It allows your business capital to be used for projects which will hopefully help your business grow and make increased profits. Leasing lets you pay for your assets as they are being used by your business over time. There are also tax benefits which enable 100% of lease repayments to be written off against profits.
Q. Wouldn't a bank loan or overdraft be better than leasing?
A. A bank loan is a viable option but several issues must be considered
If interest rates rise a bank loan may become more expensive
Bank loans reduce your available credit facilities thereby affecting future borrowing opportunities.
From a tax perspective only the interest payable on the bank loan and the capital allowances are tax deductable
With an overdraft or loan there is always a small possibility that the bank may decide to withdraw the facility during more difficult times of trading or that rates could rise in line with banking policy.
Q. What if I need to add onto or upgrade my assets in the future?
A. With a Lease rental agreement, you can add onto it or upgrade it anytime you need to in the future. This allows you to continue to meet your future needs and remain in control of your budgets.
Q. What happens at the end of a lease contract?
A. In most cases you will be offered the option to purchase the equipment at the end for a nominal fee upon expiry of the lease.
How Diverse Finance can help:
- Help you choose the most appropriate way to finance the assets you require –business loan, lease/contract purchase or straight lease
- If the assets are vehicles, we can source them and secure the best prices
- Prepare the finance application on your behalf and we can assist with business plan preparation
- Collect quotes from a variety of lenders
- Discuss these quotes with you and help you choose the one most appropriate for your business circumstances
- Liase with your chosen lender to ensure the quickest possible delivery of funds
- Get to know you and your business better so that we can help you to plan ahead for future growth
- Use our network to access and secure the best deals on your behalf.
