asset finance - finance lease

Finance leases explained

Does your business need new vehicles or essential equipment but lacks the capital to purchase them upfront? A finance lease can help. Instead of paying a large amount all at once, it lets you get the assets you need without putting a strain on your business finances.

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What is a finance lease?

A finance lease is a flexible financing option that allows your business to lease an asset, such as a vehicle, piece of equipment, or machinery, without paying for it upfront. Instead, the lender purchases the asset on your behalf and leases it to you for an agreed period.

During this period, your business will have full use of the asset. The key benefit is that it helps you manage cash flow more effectively by spreading the cost of acquiring the asset over time. And you may even be able to claim lease payments as tax-deductible expenses.

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How does a finance lease work?

Here’s a step by step guide of how a finance lease works: 

  1. You identify the asset your business needs, whether it's machinery, a vehicle, or equipment. 

  2. Your business applies to one or more  lenders to finance the lease of the asset

  3. If your application is approved and you accept the agreement, the lender buys the asset on behalf of your business.

  4. You receive the asset and can start using it in your operations immediately

  5. Your business makes regular payments to the lender, which cover the asset's depreciation, interest, and other costs.

  6. At the end of the lease term, you may have the option to purchase the asset, or return it, depending on the agreement and your business needs. 

Optional final payments and asset disposal

At the end of a finance lease, your business may be presented with several options for the asset, you will be able to either: 

  • Purchase the asset at its residual value.

  • Upgrade to a new model through a new lease.

  • Return the asset to the lessor with no further responsibility.

  • Extend the lease if you still need the asset.

If you choose to buy the asset, you might need to make an optional final payment which corresponds to the residual value of the asset. Alternatively, returning the asset allows you to walk away without the burden of ownership.

The flexibility of these options makes a finance lease an attractive solution for businesses seeking to  upgrade equipment or vehicle without large upfront payments.

How is a finance lease accounted for on your balance sheet?

A finance lease involves recording both the asset and the corresponding liability for future lease payments on your balance sheet. This is required under IFRS 16, which came into effect on January 1, 2019. Under this standard, all finance leases must be recognised on the balance sheet, which can impact your borrowing capacity. It’s important to carefully consider these implications with the guidance of an accountant.

Asset depreciation and lifespan

Understanding how depreciation and asset lifespan work in finance leases is important for making informed financial decisions for your business. Over the lease term, the value of the asset decreases due to wear and tear. This depreciation will impact:

  • The value of the asset at the end of the lease term (its residual value).

  • Your lease payments: your monthly payments are structured to cover depreciation, plus interest and fees.

This means that you’ll want to keep in mind the asset’s useful life and how it affects the financial terms of the lease. Assets that are well-maintained retain a higher residual value, giving you more flexibility and options at the end of the lease.

What types of assets can my business lease?

Your business can lease a wide range of assets such as:

  • Vehicles: cars, vans, and trucks for employee transport, deliveries, or logistics.

  • Equipment and Machinery: tools, industrial machinery, and IT systems critical for business operations.

  • Office Furniture: desks, chairs, and other office essentials.

It's also worth noting that your business can hold multiple finance leases at the same time, allowing you to lease various assets as needed to support growth and operations.

An example of a finance lease

Here's an example of how a finance lease would work:

Let's say that a business, XYZ Restaurant Chain, needs kitchen equipment for its new restaurant worth £30,000. Instead of paying the full amount upfront, they apply to ABC Lender for a finance lease. ABC Lender agrees to purchase the equipment on their behalf and lease it to them for five years. During those five years, XYZ Restaurant Chain makes monthly payments to ABC Lender covering depreciation, interest, and fees.

Here’s an example breakdown of the costs: 

  • Equipment cost: £30,000

  • Lease term: 5 years

  • Interest rate: 6%

  • Monthly payments: £590

  • Total payments over 5 years: £35,400

Upon completion of the lease term, XYZ Restaurant Chain can choose to buy the equipment at its residual value, or return it to the leasing company.

What are the advantages and disadvantages of a financial

Advantages of a financial lease

Disadvantages of a financial lease

You can preserve your business cash flow by avoiding tying  up your capital in large asset purchases.

Unlike other lease types, you may not own the asset at the end of the lease term.

With fixed monthly payments, you’ll be able to budget effectively.

You're committed to making payments for the entire lease term, even if your needs change.

Your business could enjoy potential tax benefits by claiming lease payments as expenses.

Due to the interest added, you may end up paying more for the asset than its outright purchase price.

What other options are available for your business?

In addition to finance leases, your business can explore several other financial arrangements to acquire assets, each with its own benefits and accounting treatments:

Outright purchase

This involves paying the full cost of the asset upfront, giving your business immediate ownership and full control. This option is ideal for businesses with available capital who want to avoid incurring interest payments, ongoing payments and have full responsibility for the asset, including maintenance and insurance.

Hire purchase

With a hire purchase agreement, your business pays an initial payment followed by instalments over an agreed period. Ownership of the asset transfers to your business once the final payment is made. This structure is beneficial if you want to spread costs over time while eventually owning the asset. During the repayment period, the asset is treated as a fixed asset on your balance sheet, allowing you to claim tax benefits from depreciation. Insurance and maintenance are typically your responsibility, and it's a good option if long-term ownership is important.

Asset finance

Asset finance allows you to secure a business loan against the asset to fund its purchase. This financial arrangement offers flexibility in terms of repayment structure and is often preferred when businesses need the asset but lack immediate capital. The asset appears as a fixed asset on your balance sheet, and you may benefit from tax benefits. Similar to hire purchase, the asset is owned by your business after full repayment, with the associated responsibility for maintenance and insurance.

Operating lease

An operating lease is a rental agreement that allows your business to use the asset without taking ownership. This option is suitable for businesses needing the asset for a short term period or when keeping up with the latest technology is essential. Since you do not assume ownership, the asset doesn't appear on your balance sheet, and asset depreciation is not a concern. However, depending on the lease terms, maintenance and insurance may still be required. Operating leases typically have lower upfront costs, making them ideal for businesses focused on cash flow management.

Finance lease checklist: How to determine if it's the right choice for your business

By answering the following questions, you’ll have a clearer idea of whether a finance lease is the best option for acquiring the assets your business needs:

  • Do you need to preserve cash flow for other investments or operations?

  • Is long term ownership important to your business, or would you prefer flexibility at the end of the lease?

  • Will the asset’s value depreciate quickly, making leasing more cost-effective than purchasing?

  • Do you prefer predictable, fixed payments that make it easier to budget?

  • Can you benefit from potential tax savings by claiming lease payments as expenses?

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