Operating leases and the impact on business debt
What to look out for
- Red If a company takes on too much debt, it could have trouble making interest payments which could hit their credit score
- Amber Finance or ‘capital leases’ and operating leases are another form of business debt for acquiring equipment
- Green The responsible use of debt can help a business when cash is not readily available and improve the potential for growth
An operating lease is ideal for a business looking to secure an asset without paying a lump sum up front. Discover the differences between a finance and operating lease.
Why would you acquire business debt?
If your business needs to make a large purchase it can’t afford with its own funds, you can borrow money to acquire the item, putting the business in debt. A debt arrangement gives a borrowing business access to money on the condition it is paid back at a later date, usually with interest (and sometimes additional fees).
What are the different types of business debt?
Loans are the most common form of business debt, including commercial mortgages , equipment finance and credit card debt. In general, the borrower is required to repay the balance of such loans by a certain date, which can be anything from a few months to a few decades in the future.
Loan terms usually include an amount of interest that needs to be paid annually, expressed as a percentage of the outstanding loan amount. Interest is generally higher for borrowers of types of finance that represent a greater risk to the lender. There may also be other fees that when combined with interest payments, make up the annual percentage rate (APR).
With credit cards, the debt changes depending on expenditure and how much is paid off each month. Interest is charged on any outstanding balance that isn’t paid off and there is a pre-determined limit to the debt.
Another type of business debt is corporate debt, which includes bonds and commercial paper. With bonds, companies generate funds by selling the promise of repayment to investors. Bonds usually have a set interest rate (or ‘coupon rate’).
For example, if a business wants to raise £1 million to purchase new equipment, it can issue 1,000 bonds with a face value of £1,000 each. Bondholders are then promised repayment of the face value of the bond by a certain future date (maturity date) in addition to regular interest payments.
Commercial paper is shorter-term corporate debt, typically maturing in 270 days or less.
What about leasing?
Finance or ‘capital leases’ and operating leases are another form of business debt for acquiring equipment for the business.
The main difference between finance lease and operating lease arrangements is that in the former, the risks and rewards related to ownership of an asset are transferred to the lessee for the duration of the lease term, while they remain with the lessor in the case of an operating lease.
With a finance lease, the lessor essentially finances the asset and earns interest during the term. The lessee has use of the asset for its entire lifespan, with ownership transferring to them at lease end. The types of assets often offered under this arrangement include aircraft, railway wagons, lands, buildings, heavy machinery, diesel-generating sets and ships.
In an operating lease, the lessee returns the asset to the lessor when the lease term ends. This arrangement is more common for smaller assets. You may be asking ‘is contract hire an operating lease?’. It is, particularly if related to commercial vehicles.
Finance lease vs operating lease – what are the accounting differences?
In cases where it is difficult to choose between finance or operating lease operations, it’s useful to understand a few accounting terms.
Operating lease accounting (the accounting treatment of an operating lease) assumes that the lessor owns the leased asset, and the lessee uses the asset for a fixed period of time.
But FRS 102 – one of three principal UK accounting standards introduced as part of the new UK GAAP requirements in 2015 – sets out examples of situations that would normally lead to a lease being classified as a finance lease.
An FRS 102 operating lease disclosure is the requirement to disclose the total minimum lease payment due over the lease term.
This is important to understand as the recognition of additional finance leases will lead to the recognition of new assets and liabilities and potentially a higher expense in the profit and loss account.
In some cases, you might need to report a lease operating expense. Oil and gas organisations, for example, incur costs when using leased equipment to bring subsurface minerals to the surface and converting them to marketable products.
What are the risks of business debt?
If a company takes on too much debt, it could have trouble making interest payments on borrowed funds, especially if there is a drop in income. This could hit their credit score, put off potential investors and, worst case scenario, lead to bankruptcy.
Debt is used in different ways across industry sectors, so the level of debt appropriate for a business varies. Different metrics are used to determine the level of debt (also known as leverage) that is healthy for a company to carry.
But debt isn’t always a bad thing is it?
Not at all. Think of business debt as a tool that businesses can make use of to obtain finance, something often necessary, whether to develop new products or services or raise funds without giving up ownership interests.
The responsible use of debt can help a business when cash is not readily available as well as improve the potential for businesses to grow and develop.
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