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Simply put, a finance lease is a type of lease agreement that allows your business to pay for the use of an asset, vehicle, or piece of equipment for an agreed period.
With a finance lease, the lender will purchase the required asset on your behalf and rent it to you over a chosen number of years, or for the economic life of the asset.
As long as you stick to the terms of your finance lease agreement, you'll have unrestricted access to the asset for the duration of the contract and can even add it as a tax deductible expense to your business balance sheet.
In a finance lease agreement, the lender will purchase the asset on behalf of your business and then lease it to you for an agreed period of time. Your business will then make regular payments covering the depreciation of the asset, plus interest and any other associated costs.
Once the agreement ends, you can either extend the contract, replace the asset with one that’s more up to date, purchase it for the residual value, or simply walk away with no further responsibility for the asset.
A finance lease can be used to acquire various assets crucial to your business operations. This includes cars, vans, trucks, equipment, machinery, and even office furniture. Here are some specific examples:
Acquire company cars for your employees without the need for a large upfront payment.
Equip your business with vans for deliveries, transportation, or mobile services.
Upgrade your fleet with trucks for logistics or construction purposes.
Here’s an example of how a finance lease would work:
Let's say that a business, XYZ Couriers, needs a new delivery van worth £30,000. Instead of paying the full amount upfront, they apply to ABC Lender for a finance lease. ABC Lender agrees to purchase the van on their behalf and lease it to them for five years. During those five years, Company XYZ makes monthly payments to ABC Lender covering depreciation, interest, and fees.
Here’s an example breakdown of the costs:
Van cost: £30,000
Lease term: 5 years
Interest rate: 6%
Monthly payments: £590
Total payments over 5 years: £35,400
Upon completion of the lease term, XYZ Couriers can choose to buy the van at its residual value, or return it to the leasing company.
Unlike an operating lease, where the asset doesn't appear on your balance sheet, a finance lease involves recording both the asset and the corresponding liability for future lease payments. This can impact your borrowing capacity, so you may want to consider the implications carefully with an accountant.
Another common way to avoid the cash flow impact of buying an asset outright is to use asset finance. Asset finance is a type of business loan where the funding is secured against the assets. Here are some of the key differences between these two approaches:
In a finance lease, a business can use the asset over the term, without necessarily owning it outright.
On the other hand, asset finance involves immediate ownership from the outset for the business.
Finance leases offer flexibility and lower initial costs, while asset finance provides greater control and ownership benefits.
Aside from finance leases, businesses have several other options for purchasing assets:
This involves buying the asset in full using cash that the business already has. With outright purchase, the business gains immediate ownership and full control over the asset.
In a hire purchase agreement, the business pays for the asset in instalments over a fixed period. Ownership of the asset transfers to the business once the final payment, including any interest, is made. This option provides a structured repayment plan and eventual ownership.
With an asset finance loan, the lender provides funding for the purchase of the asset, and the business repays the loan amount plus interest over the loan term. This option offers flexibility in terms of repayment structure and may require less upfront capital than outright purchase.
An operating lease does not transfer ownership of the asset. Instead, it allows the business to use the asset for a specified period while making regular rental payments.
While similar, a finance lease and an operating lease differ in three key areas: ownership responsibilities, length of term and treatment on your balance sheet.
In a finance lease, the business typically assumes ownership risks and rewards and the lease often covers most of the asset's useful life.
On the other hand, an operating lease is more like renting, where the lender retains ownership, and the lease term is usually shorter.
Additionally, finance leases are recorded on the business’ balance sheet, while operating leases are generally off-balance-sheet arrangements.
A finance lease involves the business assuming most of the ownership risks and rewards, with the option to purchase the asset at the end of the term.
In a contract hire agreement, the lender retains ownership throughout the term, and the business returns the asset at the end of the agreement without the option to buy.
In a finance lease, the lender retains ownership of the asset, and the lessee makes regular payments covering depreciation and interest, with the option to purchase the asset at the end.
In a hire purchase agreement, the business takes immediate ownership of the asset upon completion of all payments, with each payment contributing towards ownership.
In a finance lease, the lessee is the entity (the individual or business) that uses the leased asset and makes lease payments to the lessor (the lender).
The lessor is the lender that owns the asset and leases it to a business for an agreed period.
