Finance: Leasing-Part II

In the previous article, we had seen what is leasing about, with the help of a simple example, and the benefits of leasing.   In this article, we shall examine the types of lease transactions, and the difference between them.

Types of Leasing:   There are basically two types of leasing-the Finance Lease or Capital Lease, and the Operating Lease.

Finance Lease:  A Finance Lease, also called a Capital Lease, is a commercial contract, wherein the lessor, at the instance of the lessee, places an order for an asset, as per specifications provided by the lessee, and such asset is leased out to the lessee, on certain terms and conditions.

The standard terms and conditions in a lease contract like this, is that the ownership of the asset remains with the lessor, and the lessee will have the right to the beneficial use of the asset.   Further,  he would be obliged to take proper care of the asset, and ensure its upkeep.   And as a consideration for the use of the asset, the lessee would have to pay a certain sum of money every month in the form of lease rentals.

At the end of the lease period, the lessee would have the option to buy out the asset from the lessor, at a very attractive price.   And since it is he that has used the asset all the time, the lessee is sure of the quality and the remaining life of the asset, which enables him to take a correct decision.   As for the lessor, he would have recovered the major part of  his investment on the asset from the lease rentals, and would also have the benefit of the residual value of the asset, that he could sell to the lessee, or others.

Operating Lease:  A Operating Lease is similar to a Capital or Finance Lease, to the extent that the ownership of the asset lies with the Lessor.   And the Lessee enjoys the constructive possession of the asset, enabling him to make money out of the same, without actually owning the asset.  

However, the operating lease cycle is generally for a shorter period vis a vis the life of the asset.   For instance, if the productive life of the asset is, say, 20 years, then the lease period may be only for 5 years.   Operating lease, generally, does not provide for the sale of the asset at the end of the lease period.

Difference between Finance Lease and Operating Lease: 

The Finance lease is generally long term, covering almost the entire productive life of the asset, whereas the Operating Lease is generally short term in comparison.

The Finance Lease provides for the purchase of the asset by the lessee at the end of the lease period, which is not the case with the Operating lease.

In the Finance lease, the lessor recovers the major part of his investment in the asset, if not the entire cost, and the residual value of the asset is not much.   Whereas, in the Operating lease, since the lease period is a short one, the lessor does not recover the major part of his investment in the asset.   However, the residual value of the asset is quite high.

Generally, the Finance lease may work out to be cheaper option to the lessee compared to the Operating lease, as in the latter case,  the monthly rentals, would in all probability, include a risk premium.

Summary:  Leasing, as a financing option, has its pluses and minuses.   It really depends upon the requirements of the lessee, and how much freedom he has to exercise his options for other, cheaper sources of finance.

                                                                                                             Concluded