Equipment Leasing and Financing

logo white
Call Us Now

(800) 268-1038

Capital Lease or Loan: Breaking Down the Financial Implications

Our Blog
difference-between-a-capital-lease-and-a-loan

Understanding the difference between a capital lease and a loan is crucial for business owners who need new equipment but want to avoid high upfront costs and depreciation. Here’s a quick rundown:

  • Capital Lease:
  • You account for the asset as if you own it.
  • Counts as debt on your balance sheet.
  • Ownership may transfer to you after lease ends.

  • Loan:

  • You own the asset outright once you repay it.
  • Counts as an owned asset and debt obligation.
  • Depreciation and maintenance costs are on you.

Making the right choice can save money and maintain cash flow.

I’m Vincent Cerniglia, with years of experience at Noreast Capital Corporation guiding businesses through equipment financing options. Let’s explore the key financial elements to help you decide between a capital lease and a loan.

Key Financial Comparisons between Capital Lease and Loan - difference between a capital lease and a loan infographic comparison-2-items-formal

Understanding Capital Leases and Loans

What is a Capital Lease?

A capital lease is like a rental agreement, but with a twist. It allows you to use an asset, such as equipment or machinery, while giving you ownership-like benefits for accounting purposes.

Key Features

  • Ownership: You don’t own the asset outright, but for accounting, it’s treated as if you do. At the end of the lease term, you might have the option to buy the asset at a bargain price.
  • Balance Sheet: The asset appears on your balance sheet as if you own it. This means both the asset and the corresponding lease liability are recorded.
  • Depreciation: Since the asset is on your balance sheet, you depreciate it over time. This spreads the cost of the asset across its useful life.

To qualify as a capital lease, one of these conditions must be met:
– Lease term is 75% or more of the asset’s useful life.
– You can buy the asset at a bargain price at the end of the lease.
– Ownership transfers to you at the end of the lease.
– Present value of lease payments is 90% or more of the asset’s fair market value.

This type of lease impacts your financial statements by adding both an asset and a liability, which affects your financial ratios and borrowing capacity.

What is a Loan?

A loan is a straightforward borrowing arrangement where you receive money to buy an asset and agree to repay it over time with interest.

Key Features

  • Ownership: You own the asset from day one, but you also have a debt obligation.
  • Interest: Loans come with interest, which means you’ll pay back more than you borrowed. The interest rate can be fixed or variable.
  • Amortization: Loan payments are usually structured to pay off the debt over a set period. Each payment reduces both the principal and the interest.

Balance Sheet

  • Asset: The purchased asset appears on your balance sheet.
  • Liability: The loan also appears as a liability until it’s fully paid off.

Depreciation

  • As the owner, you depreciate the asset over its useful life, similar to a capital lease. This reduces your taxable income over time.

Loans are ideal for businesses that prefer ownership and can manage the interest payments and depreciation costs.

Understanding these fundamental differences between a capital lease and a loan will help you make informed financial decisions that align with your business goals.

Difference Between a Capital Lease and a Loan

Financial Reporting Differences

Accounting Treatment

One of the biggest differences between a capital lease and a loan is how they are treated in accounting.

  • Capital Lease: Treated like asset ownership. The leased asset and corresponding liability are recorded on the balance sheet. This means both the asset and the liability will appear on your financial statements.
  • Loan: Also treated as asset ownership. The purchased asset and the loan liability are recorded on the balance sheet. However, the borrower owns the asset outright, unlike in a capital lease where ownership transfers at the end of the lease term.

Balance Sheet Impact

  • Capital Lease: Both the asset and the lease liability increase your total assets and liabilities. This can impact your financial ratios, such as the debt-to-equity ratio.
  • Loan: Similar impact as a capital lease. The asset and the loan liability will also increase your total assets and liabilities.

P&L Impact

  • Capital Lease: Depreciation expense and interest expense are recorded on the profit and loss (P&L) statement.
  • Loan: Interest expense is recorded on the P&L, and the asset is depreciated over its useful life. This means you will also see depreciation expense.

Tax Implications

  • Capital Lease: You can deduct both the interest and depreciation expenses, potentially lowering your taxable income.
  • Loan: Interest payments and depreciation are also tax-deductible, providing similar tax benefits as a capital lease.

Impact on Business Financial Ratios

Leverage Ratios

Leverage ratios measure the amount of debt a company uses to finance assets.

  • Capital Lease: Increases your leverage ratios because the lease liability is considered debt.
  • Loan: Similarly increases your leverage ratios due to the loan liability.

Profitability Ratios

Profitability ratios measure a company’s ability to generate profit.

  • Capital Lease: The impact on profitability ratios can be mixed. While depreciation and interest expenses reduce net income, the use of the asset can generate revenue.
  • Loan: Also affects profitability ratios through interest and depreciation expenses. However, owning the asset can potentially generate higher long-term profits.

The difference between a capital lease and a loan in terms of financial ratios largely depends on how the liabilities and expenses impact your specific business metrics.

Understanding these differences is crucial for making informed decisions that align with your business goals and financial health.

Advantages and Disadvantages of Capital Leases and Loans

Pros and Cons of Capital Leases

Pros:

  • Flexibility: Capital leases can offer more flexible terms compared to traditional loans. For example, you might negotiate terms that align with your cash flow needs.

  • Upgrade Options: With capital leases, businesses often have the option to upgrade equipment at the end of the lease term. This is particularly useful in industries with rapidly advancing technology.

  • Lower Initial Costs: Typically, capital leases do not require a large down payment, making it easier for businesses to acquire expensive equipment without a significant upfront investment.

Cons:

  • Ownership: Unlike loans, you don’t own the equipment outright until the end of the lease term, and even then, you may need to make a final payment to gain full ownership.

  • Long-term Costs: Over the long run, capital leases can be more expensive than loans. The total cost of leasing may exceed the purchase price of the equipment.

  • Risk of Obsolescence: If the leased equipment becomes outdated before the lease term ends, you’re still obligated to make the lease payments, which can be a financial burden.

Pros and Cons of Loans

Pros:

  • Ownership: With a loan, you own the equipment from the beginning. This can be beneficial if the equipment has a long useful life and does not become obsolete quickly.

  • Interest Rates: Loans can sometimes offer lower interest rates compared to lease payments, especially if you have a strong credit history.

  • Tax Benefits: Loans can provide tax benefits through deductions on interest payments and depreciation of the equipment. This can result in significant tax savings for your business.

Cons:

  • Collateral Requirements: Loans often require collateral, which can be a risk if you’re unable to make the payments. This collateral is typically the equipment itself or another valuable asset.

  • Higher Initial Costs: Loans usually require a down payment, which can be a significant upfront expense. This might strain your cash flow, especially if you’re a small business.

  • Long-term Costs: While owning the equipment can be beneficial, it also means you’re responsible for maintenance, repairs, and potential upgrades. This can add to the long-term costs.

Capital Lease vs Loan

Understanding the difference between a capital lease and a loan involves evaluating these pros and cons in the context of your business needs, financial health, and the type of equipment you’re acquiring.

Next, we’ll look at how to choose between a capital lease and a loan, considering various factors such as cash flow, tax strategy, and equipment lifespan.

How to Choose Between a Capital Lease and a Loan

Factors to Consider

Choosing between a capital lease and a loan can be complex. Here are some key factors to help you decide:

1. Business Needs

First, assess your business needs. Do you need the latest technology that changes quickly, like computers? Or are you looking for long-lasting equipment like machinery?

Example: A graphic design firm might prefer a capital lease for computers to stay updated with new technology. A construction company, on the other hand, might choose a loan for durable machinery that doesn’t become outdated quickly.

2. Financial Health

Your business’s financial health is crucial. Look at your current profits, expenses, and overall financial stability.

Question to ask: Is your business currently profitable, and what can you afford per month?

3. Equipment Type

The type of equipment you need can influence your decision. Equipment with a long lifespan might be better suited for a loan. For equipment that becomes obsolete quickly, a capital lease might be the better option.

Example: Medical practices might lease diagnostic machines to keep up with advancements in medical technology.

4. Cash Flow

Evaluate your cash flow. Capital leases generally have higher monthly payments compared to loans. However, loans might require a significant down payment.

Tip: An operating lease might be a better fit if you have tight cash flow, as it typically involves lower monthly payments.

5. Tax Strategy

Consider the tax implications. With a loan, you can potentially write off the interest and depreciation. A capital lease also allows for depreciation but with different tax benefits.

Fact: Section 179 allows businesses to write off the full purchase price of qualifying equipment, which can be beneficial if you opt for a loan.

6. Equipment Lifespan

Think about the lifespan of the equipment. If the equipment has a long useful life, owning it through a loan might be more cost-effective in the long run.

Example: Heavy machinery with a long lifespan might be better financed with a loan, allowing you to own the asset outright after the loan term ends.

Understanding these factors can help you make an informed decision between a capital lease and a loan. Next, we’ll answer some frequently asked questions about capital leases and loans.

Frequently Asked Questions about Capital Leases and Loans

What is the difference between a lease and a loan in accounting?

A capital lease and a loan are treated differently in accounting. Here’s a quick breakdown:

  • Capital Lease: With a capital lease, the lease is treated as if the lessee owns the asset. This means the asset and the lease liability are recorded on the balance sheet. The lessee also records depreciation on the asset and interest expense on the liability. This can make your balance sheet look more leveraged.

  • Loan: When you finance equipment with a loan, you purchase the asset outright and record it as an asset on your balance sheet. The loan amount is recorded as a liability. Over time, you pay down the loan principal and record interest expenses. You also depreciate the asset over its useful life.

Example: If you lease a piece of equipment, it shows up as both an asset and a liability on your balance sheet, similar to if you had taken out a loan to buy it.

Is a lease or a loan better for managing cash flow?

The choice between a capital lease and a loan can significantly impact your cash flow:

  • Lease: Leasing typically requires lower monthly payments compared to loan repayments. This can free up cash for other business needs. For instance, an operating lease usually has lower payments than a capital lease, making it easier on your monthly budget.

  • Loan: Loans might have higher monthly payments due to interest and principal repayments. However, owning the equipment outright after the loan term can be a financial advantage in the long run.

Example: If your business needs to conserve cash for other investments, leasing might be more favorable. On the other hand, if you expect the equipment to generate significant revenue, a loan might be more beneficial.

Why would a company choose a capital lease over a loan?

Companies might opt for a capital lease for several reasons:

  • Flexibility: Capital leases can offer more flexibility at the end of the term. You might have options to purchase the equipment at a reduced price or continue leasing it.

  • Tax Benefits: Depending on the lease structure, you might be able to take advantage of different tax benefits. For example, lease payments can sometimes be fully deductible as business expenses.

  • Balance Sheet Management: Although capital leases do appear on the balance sheet, they might be structured in a way that aligns better with a company’s financial strategies compared to traditional loans.

Case Study: A tech company might choose a capital lease for its servers. This allows them to upgrade to newer technology at the end of the lease term without the burden of selling outdated equipment.

These FAQs should help clarify the difference between a capital lease and a loan. Understanding these distinctions can guide you in making the best financial decision for your business. Next, we’ll delve deeper into the specific advantages and disadvantages of each option.

Conclusion

Choosing between a capital lease and a loan is a significant decision that can impact your business’s financial health and operations. Understanding the difference between a capital lease and a loan is essential for making an informed choice.

Capital leases can be advantageous if your business needs flexibility and frequent equipment upgrades without the burden of ownership. For instance, leasing high-tech equipment like servers allows you to stay current with technology trends, as seen in our tech company case study.

On the other hand, loans might be more suitable if you prefer ownership and want to amortize the equipment over its useful life. They offer tax benefits through interest deductions and can be a good fit for long-term, stable assets.

Decision Guidance

To decide whether a capital lease or a loan is better for your business, consider the following:

  • Cash Flow: Leases often have lower upfront costs and flexible payment options, which can be aligned with your cash flow.
  • Tax Strategy: Leases can allow for full expense write-offs, while loans offer interest deductions and depreciation.
  • Equipment Lifespan: If the equipment quickly becomes obsolete, a lease might be better. If it has a long useful life, a loan could be more cost-effective.

At Noreast Capital, we understand that every business has unique needs. Our experts can help you evaluate your options and choose the best financing solution. Whether you’re looking to lease or buy equipment, we’re here to support you every step of the way.

Ready to explore your options? Learn more about the difference between leasing and buying with Noreast Capital.

small business financing - difference between a capital lease and a loan

For more information Call:

OR

Reach Out Now

"*" indicates required fields

Name*

Related Posts