Loan vs. Lease? Making the Right Choice for Your Business
Recently, one of our clients asked our advice relating to loan vs. lease equipment. It was a good time to have the discussion since this decision can affect their restricted debt covenants (i.e., current ratio, funds flow coverage ratio, etc.). Immediately, we analyzed the loan vs. lease decision for equipment based on the respective terms offered by the lender and determined that the lease option is better due to the following advantages:
1. The lease offers a lower monthly payment as compared with the loan, which improves the client’s cash flow.
2. The lease offers an option to purchase the equipment at the end of the lease term at fair value. Thus, technically, it is like the client has already owned the equipment and just delays the financing of the remaining value till the end of the lease term. With the loan option, the client would have to finance the full amount up front.
3. The lease will not affect the restricted debt covenants that are already in placed due to the client’s current financing with the lender. The loan will increase the client’s current and long-term liabilities and its long-term assets, thus it can result in unfavorable debt covenants. In addition, the loan itself usually will contain its own restricted debt covenants and require all of the client’s assets be pledged as collateral; whereas the lease does not contain debt covenants and only the leased equipment is served as collateral.
Because of the above considerations, we concluded that the lease option was better for the client. It is important to consult with your trusted business advisor before making similar decision in that vein. You don’t want a surprise at year-end that you have violated the restricted debt covenants, as that can be very costly and difficult to fix in a timely fashion. Also, in certain situations, a loan option may be more beneficial due to other factors including accelerated first-year depreciation options.