Guide to operating leases
Simplify your business's asset acquisition and combine all ongoing costs into one monthly repayment with an operating lease.
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An operating lease is a viable business asset finance option for many businesses, involving tax-deductible ongoing repayments and reduced risk. Read on to find out whether an operating lease could suit your business.
Asset acquisition is a major consideration for many Australian businesses. Small- and medium-sized businesses can face enormous asset costs as they seek to purchase vehicles and equipment to help them compete with their larger competitors, often going into debt or leaving themselves short on working capital in the process. Luckily there are plenty of other options for Australian businesses looking to acquire the vehicles and other assets their businesses need to compete and continue to grow. An operating lease is a type of asset finance open to businesses of all sizes and carries with it a unique set of advantages and disadvantages.
How does an operating lease work?
When you enter into an operating lease agreement, you are effectively signing up for a long-term asset rental. Under the terms of the agreement, you will have exclusive rights to use the asset during the term of the lease, but the ownership of the asset is not conveyed to you or your business.
This is the primary difference between an operating lease and a finance lease: under a finance lease agreement, you are effectively paying off the asset over a long period of time and will retain ownership of the asset at the end of the lease agreement, typically following the payment of a balloon or residual sum. At the end of an operating lease agreement the assets are simply returned to the lender.
An operating lease can be a good solution for businesses that wish to keep their new business asset off their balance sheets, to enjoy certain taxation benefits, or those that would benefit from regularly updating their vehicles and other assets to the latest model without worrying about residual risk. Read on to find out more about the accounting and taxation implications of an operating lease
What types of operating leases are there?
The primary types of operating leases are as follows:
Fully maintained operating lease
This type of operating lease arrangement is suited for businesses that wish to outsource all aspects of their asset's ongoing management and would benefit from rolling all operating costs associated with the assets into one fixed ongoing payment. A fully maintained operating lease usually includes reporting, accident management, roadside assistance, tyre replacement, registration, insurance, ongoing servicing and maintenance, fuel card management and the management and payment of other ongoing considerations depending on the type of asset.
Non-maintained operating lease
As opposed to a fully maintained operating lease, a non-maintained operating lease involves a variable ongoing lease repayment amount. While the lease payment relating to the cost of the asset will usually remain fixed, other costs will be charged to you as and when they fall due. This arrangement has the advantage of ensuring that you only pay for the costs that have been incurred, but can prove difficult for some businesses due to the uncertainty and inability to budget for unforeseen expenses.
Sale and leaseback
Some lenders offering operating leases will agree to purchase vehicles and other business assets that you have already purchased, then lease them back to you under a normal operating lease arrangement. A sale and leaseback arrangement can benefit businesses that have already purchased one or more assets but now can see that it might have been more advantageous to enter into an operating lease agreement instead of purchasing the asset outright. The asset would be removed from the business's balance sheet once it has been sold back to the lender and ongoing repayments made after the new agreement has been created would generally be fully tax-deductible.
The advantages and disadvantages of operating leases
As a type of business asset finance, an operating lease has its own unique set of advantages and disadvantages. These factors must be taken into account when comparing operating leases with other asset finance options to ensure that you make the right decision to suit your business's circumstances.
Advantages of an operating lease
- No residual risk. Residual risk refers to the uncertainty surrounding the residual value of an asset at the end of the lease period. While a finance lease arrangement carries residual risk, since the asset could potentially depreciate during the term of the lease period to such an extent that the residual amount payable outweighs its value, an operating lease arrangement carries no such risk. At the end of the lease term, the assets are returned to the lender with no further payments due.
- All-inclusive fixed payments. Most operating leases involve a fixed ongoing payment that includes an amount for the lease of the asset and another amount to cover all maintenance and other operating costs associated with the asset. In the case of an operating lease of a vehicle, this will usually include all maintenance, servicing, insurance, registration, roadside assistance and regular tyre replacement. In some instances, the fixed payment could include a fuel allowance up to a certain kilometre limit, along with an allowance for tolls and other variable fees. As a pre-negotiated fixed amount, you can budget for the total cost of the asset throughout the lease period, eliminating the risk that an unforeseen expense will occur or that the asset's operating costs will be higher than originally anticipated.
- Off-balance sheet. An operating lease is a type of finance that does not appear on a business's balance sheet as either an asset or a liability. This type of arrangement can be advantageous for businesses in certain circumstances, including a business looking to improve a performance ratio such as return on assets, or a business that does not wish for its asset acquisition to affect its overall borrowing capacity.
- Tax-deductible repayments. Provided the assets are used for business purposes, the full amount of the ongoing asset repayments is generally a business tax deduction. GST paid can be claimed as a credit on your business's next business activity statement, while the remainder of the repayments are usually treated as a regular tax deduction. While this is generally the case, it pays to check with your accountant before entering into an operating lease agreement to ensure that the arrangement will have the desired taxation effects for you.
Disadvantages of an operating lease
- No ownership. While you retain the rights to exclusive use of the asset during the term of the operating lease, you do not own the asset, nor will you ever own it. At the end of the operating lease agreement the assets must be returned to the lender, leaving you with nothing to sell or to use as a deposit for another asset.
- Reduced net income. Assets acquired under an operating lease arrangement are not recorded on the company's balance sheet, though the ongoing repayments are typically recorded as an expense and appear on the company's profit and loss statement. With increased expenses relating to the acquisition of the company's new assets, the net income will be affected with the disproportionate amount of expenses being recorded. It is important to seek legal advice to determine whether, based on your business's individual circumstances, it would be more advantageous for the acquisition of a new asset to appear as an asset on your company's balance sheet or an increased expense on your profit and loss statement.
- Lack of continuity. An operating lease is a temporary arrangement for a set lease term as negotiated between you and the lender. Since you are not purchasing an asset and are merely leasing the exclusive use of the asset during the period of the agreement, there is no true guarantee of continuity of the asset following the expiry of the lease agreement. For some businesses, having access to an asset for a set number of years could be the perfect solution, such as a business that needs to acquire heavy-duty equipment to complete a specific job. For other businesses, though, the lack of continuity could make planning difficult, particularly if the assets on an operating lease will be needed on an ongoing basis, such as passenger or worksite vehicles.
Is my business eligible for an operating lease?
When a lender considers an application for an operating lease, it will take a detailed look at your business's financials and asset requirements. By learning as much as possible about your business, the lender will be able to advise you on a suitable annual kilometre limit and lease agreement length to suit your business's needs.
You will need to prove to the lender that you can meet the ongoing repayments of an operating lease. This will usually be achieved by providing the lender with detailed financial information for your business that shows your current financial situation, cash flow, assets and debts. Evidence of a good credit history will also assist with your credit application. With this information, the lender will consider your asset requirements and will determine whether it is satisfied that your business has the ability to meet the ongoing repayments as they fall due.
Operating leases are a type of business asset finance and as such, you will need to provide your Australian business number (ABN) to the lender at the outset. Most lenders will require that your business has traded for a minimum of two years before discussing an operating lease arrangement.
How to apply for an operating lease
The first step you should take when you consider applying for an operating lease is to compare your business asset finance options and seek advice from your accountant to ensure that an operating lease is the right choice for you. With specific taxation implications associated with an operating lease, it is essential to ensure that it is the right type of asset finance to suit your business's needs.
Once you have decided that an operating lease is right for you, the next step is to contact a lender that offers operating leases, like those listed on this page. Your chosen lender will ask for detailed financial information on your business and, based on this information, will offer you a pre-approved credit limit. This credit limit means that you can access credit up to this limit at any time without the need to reapply each time you wish to acquire a new business asset.
Once your finance application has been approved and all the paperwork has been signed, the lender will purchase your new business assets on your behalf and will arrange for their delivery to you. Depending on any extras that have been negotiated as part of the lease agreement, such as vehicle monitoring, fuel cards or toll e-Tags, the lender will also arrange for these fleet management services to be available at the same time or shortly after your new assets are delivered.
Frequently asked questions
How many vehicles and other business assets can be included in an operating lease?
There is no set minimum or maximum number or value of assets that can be included in an operating lease. Any limits will depend on your business's financial circumstances and your current asset needs.
What types of assets can be financed under an operating lease arrangement?
Passenger vehicles and SUVs are the most common types of asset acquired under an operating lease, though heavy commercial vehicles and commercial equipment can also be included in an operating lease by some lenders. It is always a good idea to have a rough understanding of the amount and types of vehicles and other assets you wish to acquire under an operating lease, so that you can have your questions ready when you compare lenders.
How long are the terms of an operating lease?
As with other types of business asset finance, the terms of an operating lease can vary significantly from lender to lender and depending on the type, quantity and value of the assets being purchased. The term of an operating lease will always be shorter than the estimated useful life of the asset. As a guide, operating leases tend to have terms between one and five years.
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