An operating lease is an agreement to utilize an asset without ownership rights. This agreement is similar to a rental agreement, in that the lessor allows the lessee to use the asset for a set period and under conditions permitted by the lessor.
Assets commonly associated with an operating lease include equipment, automobiles, and real estate. Instead of ownership, leasing allows businesses to utilize the asset without being subjected to high purchase costs or specific maintenance responsibilities and instead regard it as an operating expense.
How Operating Leases Work
Operating leases are agreements that represent borrowed assets in which ownership is not transferred to the business (lessee) upon completion of the lease term. These agreements offer the lessee the right to use an asset for a specified amount of time and under specific conditions.
In general, these leases are applicable to a variety of resources, usually involving assets known for their useful lifespans. This includes equipment, real estate, automobiles, or other specialized machinery. Since the assets are leased and not owned, businesses can report the asset on their balance sheet as an operating expense.
Who An Operating Lease Is Right For
An operating lease is suitable for business owners who may be seeking to finance a short or long-term lease agreement that will be utilized to fulfill business operations. There are many benefits a business can gain, from both a cost-benefit and responsibility perspective.
It may be for you if you have a business:
- That is looking for affordable monthly payments: Rather than financing a purchase, leasing is usually more affordable, offering a lower monthly payment for the term of the lease.
- That needs an asset for short-term usage: Lease terms are contracted based on the amount of time you’ll be utilizing the asset.
- That is seeking the cost-benefit of leasing and mitigating ownership risk: Lack of ownership can benefit your business because you won’t be responsible for paying for necessary repairs and maintenance of the asset.
Pros & Cons of Operating Leases
| PROS | CONS |
|---|---|
| Lessee isn’t responsible for paying for repairs or maintenance. | Depending on the lease, you may pay certain fees or accrue interest, resulting in higher overall costs over time. |
| Leasing has less risk and is more affordable than purchasing, generally with more sustainable monthly payments and long-term maintenance costs. | The market value of the borrowed asset could depreciate over time, depending on the length of the lease term. |
| The lease can be contracted with shorter commitment terms only applicable to the timeline in which you may use it. | Renegotiable terms upon lease expiration may include raised rates, fees, or new conditions of the agreement. |
| Leasing provides flexible opportunities for the asset to be upgraded or replaced. | Lease terms may restrict modifications of the asset, which can potentially limit the needs of your business. |
Pros of Operating Leases
There are many advantages to operating leases, including leasing risk, cost-benefit, and favorable terms. When leasing an asset, ownership responsibilities, such as repairs and maintenance, fall to the lessor. This allows for less risk to the lessee, while also being cost-beneficial.
Generally, leases also provide more sustainable monthly payments, which is favorable for smaller businesses that may be unable to establish their portfolio with such assets financially. As such, lease terms are typically contracted only for the amount of time you may utilize the asset, saving money long term.
A great benefit to an operating lease is that it grants businesses the opportunity to upgrade or replace assets or take advantage of short-term usage for business operations. It also allows for better cash flow management, since lack of ownership risk provides the borrower with manageable payments that aren’t considered debt, and instead are regarded as operating expenses and are eligible for tax deductions.
Cons of Operating Leases
In part, potential disadvantages to an operating lease could include fee requirements and accrued interest for an asset you won’t eventually own. It’s also worth noting that the market value of the asset could depreciate over time, depending on the lease term.
Lastly, while short-term leases generally are considered a benefit, it does subject the agreement to renegotiable terms upon lease expiration. In turn, such terms may include raised rates, fees, or new conditions added to the agreement. Lease terms may also include restricted modifications of the asset, which can limit your ability to customize the asset to your exact business needs.
Operating Lease vs Finance Lease
| Operating Lease | Finance Lease | |
|---|---|---|
| Ownership | Upon lease expiration, the lessor maintains ownership of the asset. | Upon lease expiration, lessee obtains ownership and rights of the asset. |
| Risk | Lessor is accountable for repairs and maintenance. | Responsibilities are transferred to the lessee. |
| Useful Life | Less than 75% | Greater than or equal to 75% |
| Repayment Terms | Limited lease term that covers only the utilization of the asset. | Regular principal and interest payments over a set lease term. Designed to cover the useful life of the asset. |
For operating leases, ownership of the asset belongs to the lessor, or rather, the entity in which leases to the lessee. For a finance lease, ownership is assumed by the entity who leased the asset, which shifts any risk to the lessee at the end of the lease term.
Both leases reference what’s called a “useful life” term, which is defined as the estimated amount of time an asset can be used for its proposed purpose. Generally, it can be used to create depreciation schedules and is calculated based on the number of years an asset is determined to be profitably utilized.
Operating lease terms represent less than 75% of the asset’s approximated useful life. Meanwhile, financial leases differ in that they’re equal to or greater than 75% of the asset’s approximated useful life.
Alternatives to an Operating Lease
- Equipment leasing: Equipment loans allow businesses to finance the purchase of equipment needed for their companies. Generally, they have a fixed interest rate and can be used to purchase tangible assets, such as vehicles, machinery, furniture, and computers. Contrary to operating leases, full ownership is transferred once the loan is paid off.
- Small business loans: Small Business Administration (SBA) loans are small business loans offered by lenders, which are partly guaranteed by the government. This would be a good alternative if you’re seeking to own the asset eventually or if you need more flexibility with funds. If you need guidance, see our article on how to get a small business loan.
- Line of credit: A revolving credit facility that allows flexible access to capital for purchases, or repairs and maintenance. This type of financing provides flexibility to businesses in managing their expenses, and to invest in business purchases without substantial upfront out-of-pocket costs.
Frequently Asked Questions (FAQs)
No. Similar to renting, payments for an operating lease are considered an operating expense.
Leases longer than 12 months are to be included on a balance sheet, and the lessee is required to record a lease liability and the correlated right-of-use asset.
This option is more common in a finance lease. However, depending on the lease agreement, there are opportunities that upon lease expiration the terms provide the lessee with the option to purchase the asset if they are reasonably certain they may do so.
Bottom Line
Operating leases are agreements that businesses can utilize to borrow assets for a short period instead of purchasing them, mitigating out-of-pocket costs and ownership risk. Considering many smaller or newer businesses may not have the financial strength necessary to accumulate assets needed for business operations, it allows for cost-benefit flexibility and is an important factor for balance sheet purposes.
