Capital Lease vs. Operating Lease – Everything you Need to Know
What are Capital and Operating Leases?
A capital lease is like getting a loan, the equipment used is treated as if it’s owned by the lessee and represents ownership to the extent that it’s reflected as an asset on their balance sheets. On the other hand, an operating lease is similar to renting an apartment. The payments you make during the length of the lease is considered an operational expense (money invested in securing the future of the business) and the asset doesn’t go on their balance sheets.
A perfect example of an operational expense is using an employee scheduling software platform built to make it quick & easy for your managers to build schedules as well as for your employees to receive the schedules and swap shifts with one another. To learn more about how an employee scheduling platform like Deputy can better your business, click on the button below to book your demo.
Running a business will stretch you to your limits trying to juggle everything while ensuring your organization is operating at full capacity. You have to worry about your vendors making shipments on time, employees making their shifts, ensuring you’re providing top-notch customer service, etc. Above all else, you have to make sure you’re bringing in enough money to keep the business running. This can be especially difficult when your restaurant requires you to own a number of expensive pieces of equipment that are necessary to keep the business running at top efficiency.
While the amount of equipment needed and used will vary wildly depending on the type of business you want to open, plenty of shops will find themselves having to lease certain equipment. Some of these examples include:
- Laundromats leasing washers & dryers
- Pizza restaurant leasing a brick-oven
- Car wash leasing the hydration systems for pumping water
To help business owners get over the hurdle of paying for these machines, they are given the option of leasing the equipment either through a capital or an operating lease. To give you a better idea of which would be best for your business, continue reading as we go more in-depth regarding the information for both lease types.
As we touched on a bit above, a capital lease is similar to getting a loan in that it’s viewed as being owned by the person that gets the lease. Also, the business’s balance sheet will depict the lease as an asset and will be seen as a purchase from the point of view of the person that’s leasing the equipment.
How to know that a lease is a Capital Lease
Due to some confusion revolving around which leases do and do not constitute as a Capital Lease, these four questions can help business owners clarify whether or not their lease is considered a Capital Lease.
- Bargain Price Option
Does the lease contain an option to buy the leased property at a good price?
Does the lease transfer ownership of the property to the lessee by the end of the lease term?
- Estimated Economic Life
Is the lease term equal to or greater than 75% of the estimated duration of the leased item?
- Fair Value
Is the present value of rental and other minimum lease payments equal to or exceed 90% of the fair market value of the leased property?
Who Capital Leases are Best for
Due to the nature of a capital lease, they are best for business owners that need to purchase machinery that will validate a long-term lease. So before a business owner jumps into a capital lease, they need to be sure that the equipment isn’t likely to become obsolete in the coming years. So equipment like multiple high powered ovens would be great for a capital lease because they’re very unlikely to become technologically obsolete in the coming years. On the other hand, a POS system may not be a good choice because more efficient choices are likely to come out in the coming years that you may find to be a better fit for your organization. It should also be stated that capital leases recognize expenses much sooner than an operating lease, which means that the lessee is able to claim depreciation each year on the asset.
Drawbacks of a Capital Lease
While there are plenty of beneficial aspects of getting a capital lease for your business, you need to be aware of the disadvantages so you can make an accurate decision on which lease option you want to go with. One of the biggest disadvantages of a capital lease is that since you’re seen as the owner of the equipment, you are responsible for any and all repairs that are needed for the duration of the lease. While it may not be seen as a big deal at first, fixing large machinery is much different than fixing one of your household appliances. It can be quite expensive and you’ll have to factor in money lost due to the machine being in repair. This could mean not being able to serve as many customers as well as an inability to serve a particular product that drives a lot of sales.
Another drawback of a capital lease is that since it must be recorded in your financial statements, the present value of all future lease payments will appear as debt, which is generally seen as unattractive to investors. While you may be able to explain that it’s an investment in the future of your business, it will still turn certain investors off. So if you have plans for major expansion during the duration of your lease, you may find it difficult to secure a strong team of investors with the debt on your balance sheets.
On the other side of the coin is an operating lease, which is also the leasing option that is the most common among business owners. An operating lease is the rental of an asset from a lessor but disregards the terms that transfer ownership of the asset to the lessee. So while the lessee will have unrestricted use of the asset during the rental period, they are still held accountable for the condition of the asset at the end of the lease when it is eventually returned to the lessor.
Who Operating Leases are Best for
Operating Leases are great for businesses that have to replace their assets on a recurring basis and have a need to swap out their old equipment for newer ones. For example, if you have a company car for your business, you may want to replace it after a few years. Another example is if you owned a packaging store that also did photocopies. You may want to get your photocopier on an operating lease so you can replace it every three years or so. Also, unlike a capital lease, an operating lease is seen as an expense that is kept off of a business’s balance sheet. So if you’re looking to expand your brand with the help of investors, you’ll be happy to know that an operating lease won’t work against you as a capital lease would.
Drawbacks of an Operating Lease
If you do end up choosing to go with an operating lease, you should be aware that it will result in a higher overall amount of expenses reported. Whenever a business enters an operating lease, they record fewer expenses for each period through the duration of the lease. All of these expenses then show up on the company’s income statement, as well as the revenues earned for the period, the expenses that were incurred, as well as the overall net income for the period. It is typically best for companies to report a positive net income and expenses like an operating lease will reduce the company’s overall net income. Another disadvantage is that the company has no ability to sell or modify unless they have direct permission from the lessor, this can hurt them because owning assets increases the level of equity owned by the company. Since the asset isn’t owned by the company, they are unable to benefit from a higher level of equity.
Business owners also need to take into account that when an operating lease eventually expires, the terms of the lease become completely void. While they may choose to renegotiate the terms of the lease, this lack of overall continuity will make it very difficult for the company to plan. After all, the lessor may choose not to renew the previous lease agreement, which will leave you with no equipment to run your store properly.
Your business needs equipment in order to guarantee a smooth operation and to ensure it lives up to its full potential. While the equipment can sometimes be too expensive for the owner to foot the costs themselves, they can look towards either a capital or operating lease to help take care of what they can’t afford to buy. If you’re a business owner that is debating which of the two leases you should go with, go back through this blog to get a better idea of the lease that would be the best fit for your future goals.
No matter which lease you end up going with, you’re going to need a trusted team of employees if you want your business to be successful and turn a reasonable profit. But you’ll need to do more than offer a generous employee discount, you’ll need to offer them an employee scheduling platform that makes it quick and easy for them to receive their schedules as well as swap shifts and message one another without the constant need for a manager or supervisor. To learn more about how Deputy can help your business reach its goals in terms of employee engagement and beyond, click on the button below to start your free trial so you can see it in action for yourself.
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