Asset finance, including leasing and hire purchase, provide companies with an effective and alternative way of financing and accessing the business assets they depend on to run a successful operation.
Some companies, especially newer ones, often have cash flow tied up in employees, renting office spaces and other purchased equipment, and find that asset finance is the best way to free up that cash for other mandatory purchases.
For example, on an individual scale, you might decide to finance your car instead of buying it outright. Even if you had that money in savings, you may find that you don’t want to outlay £15,000 all at once on a purchase - just in case you may need that capital later - and, instead, many consumers decide to finance their cars instead.
However, on a business level, companies do something similar where they pay a charge to use an asset for a period of time, but - unlike when you purchase a car and you own it at the end of the agreement - businesses do not always choose to own their asset at the end of the contract. So, this practice is most likely more popular than we realise and one in two listed companies rely heavily on leasing as part of their business model. So, what is the changing face of business assets, especially as we approach 2020?
Finance, Operating Leases and Hire Purchase
Before we get into the ins and outs, the two main types of lease are finance leases and operating leases.
In finance leases, all of the rights and obligations of ownership such as maintenance and insurance are transferred to the lessee (the company leasing the asset), and over the life of the agreement, the lessee will have paid at least 100% of the fair value (market value) of that particular asset.
Often companies own this asset at the end of the lease. This type of lease works best for companies who’d benefit from owning the asset at the end of the term, but could not afford the upfront purchase cost. It doesn’t work for equipment that will go out of date rapidly.
Operating leases, where traditionally less than 90% of the fair value of the asset is paid over the initial committed term of the lease, work best for those companies who do not want or need the equipment for the working life of the asset. At the end of the contract, the leasing company will take back the asset and may be responsible for the maintenance and is definitely responsible for disposal at end of life. Again, historically a company has been able to expense the outlay on an operating lease.
Once it’s off that company’s books then it’s not their responsibility. This type of lease works well for companies that need equipment to be replaced routinely such as company cars, computers, high-tech equipment, and so forth.
Historically, there has been the added benefit of operating leases not being shown on balance sheet. But this will change when IFRS 16 is implemented in 2019.
Hire Purchase, on the other hand, works where the finance company purchases the asset on behalf of the customer, the customer buys though essentially “hires” the equipment on credit, and the finance company owns the asset until the final instalment is paid by the customer.
After that final instalment, the customer is given an option to buy that asset at a nominal fee. Think of this type of finance a bit like a mobile phone shop. You get to use that mobile phone until the end of the contract providing you pay the HIRE charge, but if you want to PURCHASE that phone at the end, then you have to pay a final instalment.
How Will Businesses Have To Approach Leasing By 2020?
Effectively reporting all leases, thanks to IFRS 16’s changes, on balance sheet isn’t all doom and gloom, though. First of all, it ensures easy comparison from entity to entity for investors and presents new opportunities in the form of financial reliefs and exemptions. Secondly, it’s an opportunity to centralise and manage all company leases in a fully comprehensive way and discover how leasing affects and impacts your company's financial metrics.
It may look like there will be a rise in a business’s recorded debt and an increase in assets and liabilities, especially where shareholders are concerned, but you won’t be the only company doing so.
Financial ratios will be affected, but that data will be more accurate overall, which will mean a new and innovative approach to business can develop. Any inefficiencies or wasted spending can be highlighted and remedied.
The beauty of new, tighter regulatory standards is that your affected area of business, in this case, your lease portfolio, will need to be optimised and savings may ensue.
How Did Companies Approach Business Assets Versus Capital Before?
Prior to IFRS 16, companies didn’t have to report all operating costs associated with leases on the balance sheet. So what that means is that a company may be leasing a fleet of company cars for x amount per month but the liability for the committed payments was listed in a footnote instead of on the balance sheet for accounting and auditing purposes. The associated assets were rarely mentioned anywhere!
Now changes are coming into effect, companies can no longer footnote these leases. From a transparency point of view - for shareholders and investors - it seems like a great idea; however, company finances are often nuanced, and company leased assets can change and alter over time.
For example, a company may have committed to a two-year lease on computers. One year into that lease they may decide they need even more upgraded computers. They crunch the numbers and decide that breaking that lease will work out cheaper and more beneficial for the company overall than maintaining that lease for another year.
If the company has newer, faster computers productivity and profits will be up versus having those older computers for a year longer. So, this company decides to break the lease early, and pay associated fees.
Maybe the company found a new computer leasing company that has a better rate than the old one so now the balance sheet can’t and doesn’t accurately report and represent the total costs for the company, in assets and operating costs.
In the past, these changing conditions didn’t affect the valuation of the company or its bottom line. Companies could acquire and terminate operating leases without it reflecting on the balance sheet, and without investors asking questions about those overarching operating costs.
What Do Businesses Prefer?
Depending on the business, most businesses prefer tried and tested measures and the way things were done ‘before.’ However, this new change can be seen as a positive way forward for companies. An open balance sheet can help determine the overall health of companies and help companies have a realistic view of what’s feasible as far as operating costs.
In theory, it should allow the cream to rise more easily to the top and attract better-informed investment more readily. In short, it will help to level the playing field.
How And Why Did Leasing Become So Popular?
Leasing is an attractive option for companies who understand that leasing an asset will generate more than enough profit to meet payments for the duration of the lease. It works well for those who could not acquire the asset through cheaper means or do not have the initial capital to invest in the asset up front.
It’s a great option for start-ups companies to begin before they can afford to own the assets. It also allows companies to spread costs more evenly and predictably from month to month, matching the cost of an asset to the ongoing realisation of the benefit of it, without affecting up-front cash flow. So why is leasing more popular in recent years?
Well, for all those reasons and then some.
Leasing on a consumer level is often a way for people to own more high-end products than they might have been able to afford prior to these options, and with a have-it-now culture, leasing has been a way for people to get things immediately rather than wait to save up.
The same goes for companies in essence. It allows companies to have the newest and best now instead of later when profit margins have grown. Also, with economic pressure, it seems like a safer option - with the option to get out of the lease - than buying an asset you may not be able to use if things don’t go well or there’s an economic slump in the business. It offers more flexibility and allows a company to respond to increased and reduced trade.
Leasing often works well for companies and it is incredibly popular for people to lease anything from company cars to laptops to office furniture and more. And, as long as your finance department is realistic and solid, and you understand the terms of the lease, it’s an excellent way to balance company capital and allow the regular and sometimes necessary refresh of assets - just as long as companies understand how asset reporting will change approaching 2020.
But Leasing Is Changing: Stay Up To Date
IFRS 16 is just around the corner. Ensure your business is prepared for the changes. There are lots of documents to collate, gather, and analyse to achieve compliance. But do not worry. We can help. Download a free, 7 step plan to achieving leasing compliance: