Choosing equipment for your small business can be equal parts exciting and stressful.
Apart from selecting the right type of equipment, there are many considerations to make when choosing between leasing and buying equipment that affect your small business accounting needs. These include upfront costs, maintenance costs and of course, tax implications.
When you lease equipment, it’s similar to paying rent for office space. You make flat monthly payments for use of an asset that you do not own. On the other hand, purchasing equipment involves the acquisition of an asset via capital investment or financing.
Assessing Current Expenses and Anticipating Future Business Needs
Leasing tends to be the more popular method for new small businesses who may not be in a position to make huge capital investments straight out of the gate. Others may have the funds available in the bank but realize that it may be more prudent to hold off on large capital expenditures until they break even. The breakeven point refers to the amount of sales you need to generate just to produce a profit of zero. In other words, it’s the amount you need to earn in order to keep the doors open and stay in business. To calculate the breakeven point use this formula:
- Fixed costs / (Sales price per item – Variable cost per item) = Breakeven Point
In this equation, fixed costs are your regular recurring debits. This would include your monthly lease payment or loan payment if you choose to finance equipment.
Apart from assessing start up costs and determining break even, it is also critical to give some thought to your company’s future technology needs. Some small businesses don’t require new technology very often, while others need regular updates to stay relevant in a competitive industry. In fact, the number one benefit of leasing is that it offers businesses the opportunity to upgrade equipment at the end of a lease period.
To determine how aggressive your need for updated technology is and whether or not it makes sense for you to lease or buy, use the following checklist:
- Step 1: Determine how much equipment you use in your day-to-day operations which have a long, useful product life. Does technology change rapidly for this product making it obsolete quickly? Products with a longer life of usefulness are not the best candidates for leasing.
- Step 2: Think about assets you’ve owned over the past year and how long you have kept them. If you tend to keep your assets running for longer than a few years, you may want to consider purchasing equipment over leasing.
- Step 3: Decide your comfort level with routine maintenance. If you prefer the simplification of low maintenance requirements, it may be a better option to lease.
How Much Cash Flow Do You Need?
Putting together cash flow projections on a regular basis is important to ensuring the long-term viability of your business. Looking at past performance is an excellent starting point. However, in making your forecast, you will need to include the impact of purchasing versus leasing equipment in your calculations.
Buying equipment affects the investing cash flow and operating cash flow sections of the cash flow statement:
- Purchasing equipment using cash is recorded as a cash outflow.
- If you choose to purchase equipment via a line of credit or small business loan, monthly principal payments would also affect investing cash flows. Be sure to account for the down payment amount which is typically required with this option.
- Insurance and maintenance costs would impact operating cash flows.
On the other hand, a lease payment only affects operating cash flows. There is no need to worry about maintenance costs, etc. as these are handled by the lessor under the terms of the contract.
You can run scenario analyses to show how your cash flow would be impacted based on options to lease or purchase. The important takeaway here is to be able to anticipate upcoming events in your company’s growth journey.
For instance, if you are concerned about a new entrant in your market, you may prefer to hold onto your cash and go the route of leasing to provide you with more flexibility.
What Are Your Financing Options?
There are a number of common reasons why a small business may not qualify for financing equipment. This could be due to a lack of creditworthiness, but there are other conditions that lenders look at such as the length of time you’ve been in business and available collateral.
To understand your financing options, follow these steps:
- Step 1: Know your business and personal credit scores. It’s important to know and understand the implications of all your credit scores. You can pull your business credit from these sources: FICO®, Dun & Bradstreet®, Experian® and Equifax® and personal credit from here: Experian®, TransUnion® and Equifax®.
- Step 2: If you’re seriously considering a lease, shop around for lease terms. Ask each company to provide your prequalification lease terms in writing.
- Step 3: Take your pre-qualifications to a trusted accounting professional to determine the best options for buying or leasing new capital equipment.
What Are the Tax Implications for Your Business?
From a tax perspective, deducting the cost of leased equipment can simplify the tax filing process for your small business when compared to deducting the value of depreciation. It adds a larger deduction than deducting interest on a credit purchase. For these reasons, leasing could be favorable.
Tax Benefits of Buying v. Leasing
- Leasing: In many cases, leasing offers the greatest tax benefit because you can deduct the entire value of a lease payment, immediately.
- Purchasing via financing: You can only deduct the interest as an expense.
- Deducting depreciation: With some business assets, like automobiles, you are allowed to deduct depreciation of purchased assets. This requires some additional math, as you must understand the per item allowance to calculate deductions.
Pros & Cons of Leasing Versus Buying
Now that you’ve asked yourself the important questions, combed through your small business’s finances and talked to an accounting professional, it’s important to weigh the pros and cons of leasing versus buying for your business.
- Purchasing equipment for cash is easier than leasing. There are no cumbersome contracts to fill out nor are you required to provide detailed, updated financial records or information.
- More choice. You aren’t limited by a company’s inventory of brands. You can shop around until you find the exact model and brand you are looking for.
- Greater control. With ownership comes total control over maintenance, including making sure items are repaired quickly and to a high standard of quality.
- Equity. You will also have the option of offloading the asset when you no longer need it, providing an opportunity to recover some of the cost.
- Tax benefits. There are some tax incentives depending on what and how you purchase the asset, outlined in Section 179 of the tax code.
- The upfront cost is greater than leasing. If you purchase equipment using a line of credit for example, in most cases, you will be required to make a down payment.
- Risk of obsolescence You may end up with obsolete technology if you are using equipment that doesn’t have a long usable product life.
- Maintenance costs. You are responsible for the cost of maintenance and upgrades to existing equipment.
- Buying equipment to test it out involves risk. You may end up owning equipment that doesn’t work for you. Options to return may not always be available.
- Tax deduction. As mentioned above, leasing is tax deductible for 100% of the cost up to $500,000 for small businesses.
- Up-to-date technology. Small businesses who lease love that they can upgrade equipment often and don’t have to worry about their technology becoming obsolete for very long.
- Low upfront costs. This makes leasing a good choice for new or existing businesses that are concerned with negative cash flow.
- No maintenance costs associated with leasing. If equipment isn’t working the way it should, it’s the responsibility of the company that issued the lease to fix it.
- High total cost. The total cost of leasing an item usually exceeds its purchase price over time. For example, a 3-year lease on machinery worth $4,000, with lease payments of $160 a month would result in total payments of $5,760 over the life of the lease or 44% above the price today.
- No equity. When you lease, you do not own the equipment and therefore you will not have any equity or the option to sell the equipment to offset the cost.
- Unfavorable terms. Lease agreements can be strict and lock you in for terms that are longer than you want or need.
- Tricky maintenance standards. Maintenance standards are relative to the company leasing the equipment, and in some cases, may not meet the standards of the lessee.
- Limited choice. If a company doesn’t offer a specific brand you are seeking, you may get a similar piece of equipment from a brand you are less comfortable with.
Capital Lease v. Operating Lease
To complicate things further, you may also consider choosing between a capital lease and an operating lease. Capital leases are generally used for longer-term leases on equipment that is not expected to become obsolete in the near term. They are treated as an asset from the perspective of the lessee and a loan from the standpoint of the lessor. A capital lease gives the lessee the same benefits (and the disadvantages) of owning equipment.
An operating lease refers to an arrangement in which the lessee does not have any ownership rights to the equipment. The lease payment is recorded as an operating expense. An operating lease is usually beneficial in the case where technology needs to be replaced often.
How to Decide Between Leasing and Buying
Ultimately, this small business accounting decision must take into account a number of factors that small business owners should discuss with their trusted financial advisors.
In summary, these factors include:
- Unique cash flow needs of your business
- Creditworthiness or a business’s ability to obtain financing
- The need for new technology in day-to-day operations
- Applicable tax incentives
- Understanding the pros and cons as they apply to your current situation
- Being aware of the difference between a capital lease v. an operating lease
If all of these considerations have anything in common, it’s that there isn’t a one-size-fits-all solution in terms of buying versus leasing. Small business owners may have an idea of what will work best for their business, but they should seek advice from professionals who can look at the big picture and offer advice.
Our team of small business accounting professionals will advise you on the necessary steps to make sure your equipment meets the needs of your business today and five years from now. Our goal is to make businesses profitable, and that means we do more than just taxes and bookkeeping.
In particular, Ignite Spot offers outsourced financial reporting services to ensure you have the right reports exactly when you need them. This will allow you to make more informed decisions and stay on top of your game.
The benefits of outsourced financial reporting include the following:
- Develop a reliable reporting system for accurate analysis.
- Build awareness of cash position, profit and other lifelines.
- Understand the financial foundations of your business.
- Avoid crises and plan for future growth.
Contact our team today to learn how we can help meet your small business accounting needs.