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

Finance: Leasing-Part I

What is Leasing?   Leasing is a type of financing,  in kind (instead of cash).   A lease transaction involves the owner or lessor of the asset, say machinery, or a car, etc., transferring the right to use the same to another person called the lessee.   This transaction is formally called a lease.

In this transaction, the ownership of the asset continues to vest with the lessor.   Only the beneficial use of the asset is afforded to the lessee.   The consideration due to the lessor from the lessee is called as the lease rentals.   These rentals are normally fixed amounts payable monthly.

How it works:  John Deere, a resident of Oklahoma City had always dreamed of owning his own taxi and ferrying passengers across cities.   He loved driving and wished to combine his love of driving with a service that would take care of his livelihood.

But John did not possess the financial wherewithal to buy a car on his own and get started with his passion and his profession.   He therefore approached a local Bank with a proposal for purchase of a car for the purpose of plying it as a taxi.   The Bank, after evaluating his proposal did not find him upto the mark in regard to his creditworthiness for the USD:36,000.00 loan he had asked for.

Disappointed,  John thought of approaching a fleet owner to join them as a driver.   But his heart was not into it, and he gave up the idea.   Eventually, John contacted a Leasing company, that offered to lease out a car of his choice to John for a reasonable monthly lease rental.   John considered the proposal inside out, and decided to accept it.

Under the terms of the contract, John would get a brand new car of his choice.   He could use it for his professional activity and pay the lessor, or the owner, a fixed monthly rental.   He would also have to take proper care of the car, and keep it in good condition.   Further, at the end of the lease period, he would have the option to buy the car from the lessor, at a very attractive price.

In this way, John came to possess, albeit constructively, a brand new car to pursue his passion to drive, as well as make a livelihood out of it.   This is a simple example of how a lease transaction works.

Benefits of Leasing:  There are several benefits of leasing, both to the lessor and the lessee.

Benefits to the Lessor:  The lessor that owns the asset, may not always be in a position to utilize it for his own benefit, and thereby incur costs for maintaining the same.   Leasing offers a way of making some money out of the asset.

The lessor does not have to bother about the upkeep and maintenance of the asset, as it is taken care of, by the lessee.

The asset brings a regular income with the minimum of hassels.

Benefits for the Lessee:  The lessee may not be eligible for a Bank loan for various reasons, and leasing is an alternative finance option for him, that is more convinient, and may be cheaper.

The lessee has the option to buy the asset at the end of the lease period at a very attractive price.   Moreover, it is an asset that he himself had been using. 

If, at the end of the lease period, the asset is giving diminishing returns, the lessee can go in for a fresh lease, and get a new asset for the new lease.

Leasing has become a well established financing option for businesses, providing them with an alternative to the regular banking finance.

                                                                               To be continued

ISLAMIC BANKING SERVICES: IJARAH

Definition:  Ijarah is the equivalent of Leasing offered by Islamic Banks and Financial Institutions.   The activity of Leasing involves permitting the usage of a property, say a car, or a shop etc, owned by one person, by another, for a consideration, i.e. a monetary return.   While the ownership of the asset remains with the owner, or the lessor, the lessee, or the person that leases out the asset, will have the freedom to put such asset to beneficial use, in order to gain some benefit from the same.   There are two types of Ijarah-Ijarah Salam and Ijarah wa Iqtina.

Ijarah Salam:  Under this type of lease agreement, the lessee retains the possession of the asset for the duration of the productive life of such asset, which may be 10 years or 15 years as the case may be.  

 For example, a person takes a car on lease whose productive life is estimated to be, say 10 years.   The lessee would be entitled to the use of the car for 10 years by paying the lease rentals as agreed upon in advance,  for the fixed amount within the stipulated date without default.   The car will remain in the possession of the lessee for the duration of its productive life cycle, in this case, 10 years, after which the lessee will return the asset to the owner, who by the way, continues to retain the ownership of the car during the lease period.   This type of lease contract is convinient to both the lessor and the lessee and fulfils their respective requirements.  

Ijarah wa Iqtina:  Under this type of lease contract, the lessee has the option, though not the compulsion, to buy the asset leased out from the lessor upon completion of the lease period.   The rate at which the asset would be purchased by the lessee would be mutually decided upon by both the parties to the lease contract.   As in the first type of lease contract, the ownership of the asset vests in the lessor and the lessee would only have the right to put the asset to beneficial use.   And the lessee would be obliged to pay the lease rentals at the rate agreed upon at the stipulated intervals without default.   At the end of the lease period, the lessee would have the option of buying the asset off the lessor and become the owner of the same.   The rate at which the asset would be sold to the lessee would depend upon the quality of the asset, the remaining life cycle of the asset, the market conditions, the demand and supply position etc.

Beneficial Arrangement:  Ijarah and Ijarah wa Iqtina contracts are  beneficial to both the lessor and the lessee.   The lessor, who owns the asset,  may not have the time and the inclination to put his asset to beneficial use and may only be incurring expenditure in maintaining the same.     This arrangement provides an ideal way for him to put his asset to good use and derive some financial benefit from it.   In the same way, the lessee may have the necessary skills to utilize the asset and derive financial benefit from the same, but may not have the capital to purchase the asset.   This lease arrangement, thus provides him the medium to possess the asset without owning it and to apply his knowledge and skills to put the asset to beneficial use.   What’s more , he has the option to buy the asset from the owner, in future, if that suits his needs.   Hence it is a mutually beneficial arrangement.

As in other types of financing under the Islamic system, the Ijarah contract also relies to a great extent upon the integrity and honesty of the parties to the contract.   Some of the most important responsibilities of the parties to the Ijarah contract are:   the lessor should not only be the owner of the asset, but must have possession of the same.   Ownership without possession, or vice versa does not fulfil the requirements of this kind of contract.   In the same way, the lessee is expected to take good care of the asset, as he would if it belonged to him, even though he not the owner of the asset.

Note:  Readers please note that this article is not an exhaustive study of the Ijarah contract, but only meant to give a basic understanding of the same.