Debt Equity Finance vs. Lease Finance
Original post by Matt Petryni of Demand Media
When paying for the cost of doing business, managers usually rely on one of three options: financing costs with revenue, seeking out new investors, or borrowing against assets. Successful businesses generally borrow as little as necessary, and sometimes use lease financing arrangements to avoid new debt, or to secure lower financing costs. Lease financing is somewhat like taking on new debt, but has some key differences that should be understood when considering this option.
Debt and Equity Financing
The most common sources of capital in business are debt and equity -- borrowing from creditors and securing investments from owners or partners. Each has their advantages and disadvantages. Debt financing is sometimes preferable for short-term costs and obligations. This is because it must be paid back with interest, and does not usually convey an ownership claim to the business's assets or future profits. Equity financing is often used for long-term investments like capital assets, because the investor continues to hold an ownership interest in these assets.
A lease financing arrangement is different than taking on debt or raising investment capital. In a finance lease, a lender essentially provides a loan like they would in a normal debt, but they also get an ownership interest in the business's assets. Finance leases are usually set up so a company sells one of its major assets to a finance company, who in exchange provides them with cash. The business then arranges to rent the asset from the finance company for the duration of its useful life.
Leases do not convey either ownership interests in the whole company, nor do they necessarily result in long-term liabilities. In some cases, a business can stop renting an asset from a lease company at any point with no penalty, but failure to continue paying a debt can mean bankruptcy. In addition, the cost of capital from a lease is often cheaper, as the lessor enjoys the added security of owning the asset outright. Finance leases are usually more complicated for accounting purposes, as the method to report a lease arrangement on the balance sheet can change according to the conditions of the arrangement.
Economic evidence seems to suggest that lease financing and debt financing are generally used as alternatives to one another, although businesses often combine a balance between debt, equity and lease financing. In some leasing arrangements, the business is obligated to pay the lease until they have paid back the leasing company's purchase, which makes the arrangement highly similar to a loan. The business can even regain control over the asset at the end of the lease arrangement, or can write in the option to repurchase the asset at a discount.
- National Association of Realtors; Field Guide to Sale Leasebacks & Synthetic Leases; March 2010
- Financial Accounting Standards Board; Summary of Statement No. 98; May 1988
- "Encyclopedia of Management"; Debt vs. Equity Financing; Marilyn Helms; 2006
- New York University; The Debt-Equity Trade Off: The Capital Structure Decision; Aswath Damodaran
- University of Delhi; Lease Financing--Hire, Purchase and Factoring; Rehka Rani
- "Journal of Financial and Quantitative Analysis"; Leasing and Debt Financing: Substitutes or Complements?; An Yan; Sept. 2006
- MoneyTerms.co.uk; Finance Lease; Graeme Pietersz; 2011
About the Author
Matt Petryni has been writing since 2007. He was the environmental issues columnist at the "Oregon Daily Emerald" and has experience in environmental and land-use planning. Petryni holds a Bachelor of Science of planning, public policy and management from the University of Oregon.
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