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An equipment lease agreement is a contractual agreement where the lessor, who is the owner of the equipment, allows the lessee to use the equipment for a specified period in exchange for periodic payments. The subject of the lease may be vehicles, factory machines, or any other equipment. Once the lessor and lessee agree to the terms of the lease, the lessee gets the right to use the equipment and, in return, makes periodic payments during the duration of the lease. However, the lessor retains ownership of the equipment and has the right to cancel the equipment lease agreement if the lessee contravenes the terms of the agreement or engages in an illegal activity using the equipment.
According to the Equipment Leasing Association of America, more than 80% of American companies lease some equipment rather than purchasing it. There are thousands of leasing companies that lease equipment to companies in exchange for periodic payments. Most companies lack the budget to acquire large machines whose cost may run into millions or billions of dollars and, therefore, prefer to lease the equipment for a specific period. Some of the high-demand lease equipment includes high-technology equipment such as diagnostic tools, telecommunication gadgets, and computers.
Equipment leases are grouped into the following two categories:
A capital lease is usually long-term and non-cancellable and is used to lease equipment that the company wants to use in the long term or purchase at the end of the lease period. In this lease, the lessee is responsible for maintaining the asset and paying any insurance and taxes associated with the equipment. The equipment’s assets and liabilities are recorded in the lessee’s balance sheet during the lease period. Businesses prefer this type of lease when renting expensive capital equipment that they may not have the funds to purchase immediately.
An operating lease is usually short-term and cancellable before the expiry of the lease period. It is common for businesses that want to use the equipment for a short period or replace the equipment at the end of the lease. The lessor retains ownership of the equipment and bears the risk of obsolescence. A lessee can cancel the equipment lease agreement, with prior notice, at any time before the expiry of the lease period, but usually with a penalty.
Apart from the two types of leases mentioned above, there are other types of equipment leases that combine the features of capital and operating leases to meet the needs of both parties. For example, the lessor may opt for a hybrid equipment lease for tax and financial advantages. Leveraged leases allow the lessee to finance the lease cost by issuing debt and equity against the equipment lease payments.
An equipment lease agreement comprises certain terms that form the basis of the contract. Some of these terms may include:
The lease duration will depend on the company’s needs and the cost of the equipment. For a small business whose equipment needs may change quickly, a short lease duration is a favorable option. For expensive capital equipment, a longer lease duration is more convenient and cheaper in the long term.
The equipment lease agreement includes terms such as the timelines on payments – for example, when the periodic payments are due and the last due date for late payments.
A business considers its projected cash flows to decide if it can meet the periodic interest and principal payments. The payments are spread over several months until the expiry of the lease period or when the lessee takes ownership of the equipment if there’s an existing agreement with the lessor.
Some equipment is expensive, and the lessee needs to understand the market value of the equipment before getting into the contract. Knowing the market value helps the lessee assess the insurance costs to protect against the equipment being lost or damaged.
Depending on the type of lease, the lessee may be required to pay certain costs, such as taxes, on the equipment. Knowing the tax responsibility under different types of leases will help the lessee avoid pitfalls of unanticipated expenses.
The equipment lease agreement must include guidelines for an agreement cancellation. A business may decide to cancel the agreement midway, either because they find an alternative or because the equipment is defective or outdated. Some leasing companies may charge punitive penalties if the actual penalty rates were not disclosed at the initial stage. Technology-based equipment becomes obsolete fast, and a business may want to find alternatives quickly to beat the competition.
Lessee renewal options provide guidelines on the renewal process at the expiry of the lease period. The lessee may want reduced periodic payments or an opportunity to acquire the equipment at the expiry of the lease period.
For small businesses that lack adequate cash reserves to finance equipment lease, there are several avenues they can pursue to get lower rental costs or financing assistance. These avenues include:
In recent years, the number of leasing companies in the US has risen steadily to cater to the growing demand for leased equipment. Leasing firms vary in leasing terms, product quality, and service. A business owner should approach several leasing companies first to evaluate each firm’s terms and their equipment lease agreement. Doing a background check on each company’s reputation, as well as talking with former and current customers, can help weed out rogue firms.
Some banks advance credit to small and medium businesses to help them lease expensive equipment. Banks charge lower fees and may offer better customer service than companies that are not predominantly in the financing business and, therefore, are preferred by borrowers. Some banks also service the periodic transactions depending on your agreement with them.
Equipment dealers and distributors often own subsidiary companies that offer equipment leasing services. Visit the equipment dealers and inquire if they offer financing arrangements for their equipment.
CFI is the official provider of the global Financial Modeling & Valuation Analyst certification program, designed to help anyone become a world-class financial analyst. To learn more about leasing and other business practices, we offer the following free resources:
