Finance lease vs. operating lease – what’s the difference?

Most South African businesses need expensive assets to produce the goods and services they sell. These assets are typically cars, work vans, plant and machinery. Without them, many businesses simply cannot function. However, buying big-ticket items can create problems with cashflow and for companies with seasonal finances, spending a large sum all at once may be impossible. But not to worry. Say hello to finance and operating leases – two low-cost ways for businesses to secure the major tools they need.

A finance lease is a method of financing business assets, and it works as a long-term rental agreement, with the assets remaining the property of the finance company (also known as the lessor) that hires them out, and the lessee (you) paying for the hire of the assets. The lessee has the option to buy the asset at the end of the contract period.

A finance lease allows your business to use an asset for a fixed period and for a fixed monthly rental cost. At the end of the agreement the business will have the option to purchase the asset for a pre-agreed sum. A finance lease allows businesses to spread the cost of the asset over time and with lower monthly payments than if they were to purchase the asset.

An operating lease is also a method of financing business assets, and like a finance lease, it works as a long-term rental agreement, with the assets remaining the property of the finance company (the lessor) that hires them out, and the lessee (you) paying for the hire of the assets. However, unlike a finance lease, the lessee has no option to buy the asset and it will always return to the lessor at the end of the contract period.

An operating lease is a low-cost way for businesses to obtain the big-ticket items they need. Unlike purchase loans, the lessee, (you) does not buy the asset, you rent it and you cannot purchase the asset at the end of the contract. 

In most cases (especially with business vehicles), the agreement will include a Residual Value that is based on the period of the lease and the estimated value of the asset at the end of the contract. At the end of the agreement the asset is usually sold to a third party on behalf of the finance company. If the asset sells for more than the Residual Value, the finance company will refund a percentage of the surplus back to you. If the asset sells for less than the Residual Value, you will be liable to make a further payment to the finance company.

An operating lease allows businesses to use the asset for a lower monthly cost than buying the asset with hire purchase. Operating leases may come with included maintenance and repairs.

It depends on your business’ acceptance of risk, your tax position and your long-term capital goals.  

An operating lease is good for businesses that would rather not deal with the maintenance or administration required with some assets, and they are usually more tax efficient for businesses that don’t want their assets to showcase under an accounting record. Alternatively, financial leases are good for businesses who want to buy assets without a large upfront cost, and at a lower monthly cost and with greater tax advantages than they may enjoy with a standard hire purchase agreement.