Understanding capital leases: How they affect your business’s finances

If your company requires equipment or property but does not want to purchase it outright, a capital lease is an option to consider. A capital lease is built more like a loan, rather than normal rental agreements. A capital lease can provide the ability to control an asset similar to ownership while making periodic payments so that you can manage the cash flow. 

In other words, a capital lease allows you to utilize the equipment, but rather than providing a one-time purchase payment, you pay structured payments over time while using the equipment. However, there is more than convenience with a capital lease, it is attractive because it impacts your business’s financials. 

The reason is that just like ownership, any leased asset will show on the balance sheet as owned, with the lease obligation recorded as a liability. Therefore, the asset and lease obligation on the balance sheet impact your company’s financial ratios and influence aspects such as taxes and borrowing power. Therefore, it is extremely important that you understand a capital lease and how it impacts financial decisions while ensuring your company’s financial stability.

What is a capital lease and how does It work?

A capital lease is an extended-term agreement whereby an organization leases an item, whether equipment or real property, under terms similar to an ownership transaction. Operating leases are longer agreements where a company simply is renting an asset . With a capital lease, the company has control of the asset for a substantial portion of its useful economic life and is responsible for various ownership responsibilities, like maintenance, insurance, etc.

At the end of the lease, companies are mainly offered an option to purchase at a discount, and capital leases can be appropriate when a business anticipates they will need and want to continue using the asset long-term . One defining characteristic of a capital lease arrangement is meeting certain criteria under accounting guidelines.

If the lease transfers ownership at the end of the lease, is primarily for an asset’s useful life, or is such that the payments are substantially the same as the value of the asset, it meets the capital lease criteria. Such criteria is important because capital leases are reported on a financial statement differently from operating leases. It is very important for businesses to analyze lease agreements to understand the financial implications before committing.

How a capital lease affects your balance sheet

One of the largest ways that a capital lease affects a business’s finances is in its presence on the balance. Unlike operating leases – treated simply as an expense – capital leases appear on the balance sheet as both an asset and liability.

Essentially, so long as the company meets the payment obligations, the business is required to list the leased item as an owned asset and the amount of the debt as a liability. As a result, capital leases alter the appearance of the financial position of a business, especially when comparing with a business that relies on traditional leasing practices.

Having a capital lease on the balance sheet affects financial ratios that are meaningful to investors or lenders. A lease increases both assets and liabilities, which can impact a company’s debt to equity ratio and can depict a higher leverage.

Though, this does not necessarily mean that a company is over-leveraged and businesses need to be prepared to explain their financial position to lenders or investors. By understanding these impacts businesses can help plan for the future and understand their financial health better.

The income statement and cash flow impact

In addition to changing the balance sheet, a capital lease also has implications for the income statement and cash flows. Instead of being treated solely as an expense, the lease payments must be broken down to include depreciation on the asset, as well as an interest expense.

Depreciation is simply the allocation of the purchase price over time, while interest reflects the financing cost. In turn, this could potentially cause a business to have more expenses in the earlier years of a capital lease as opposed to a traditional lease, thus affecting net income. 

Furthermore, on the cash flow statement, capital leases are accounted for differently than operating leases.  The lease payment is split between operating activity (the depreciation) and financing activity (the portion of the payment reporting as interest expense).

This can be meaningful for a business attempting to manage cash flows, as it relates to cash available for operations. Even though you will have more work as an accountant for capital leases, it does provide long term returns, including tax benefits and ownership; thus it is a strategic view overall as an organization.

When does a capital lease make sense for your business?

The choice of capital lease is based on the company’s long-term requirements and financial plans. When a company needs costly equipment but does not want to purchase the entire capital item immediately, a capital lease offers a means to utilize the asset while paying for it over time.

For some industries, notably manufacturing, construction, and healthcare, timely access to equipment is important and very expensive. Similarly, businesses that expect to use the asset for most of its useful life will prefer a capital lease, as they will obtain ownership of the capital asset. However, consideration must be given to the impact of financial reporting. 

Because there is debt added to the debt load, the capital lease may impact loan covenants or financial ratios. Some companies may prefer operating leases to manage liabilities and either pay as you need, or in the case of an operating lease, lower monthly payments.

Ultimately, the decision is simply a balance of financial strategy, tax benefits, and long-term business objectives. Companies can manage finances through careful evaluation of lease terms to consider the best option for future appreciation of capital assets.

Making the right choice for your business’s finances

Knowing how a capital lease affects your financial statements is key to making informed business decisions. Unlike a simple rental agreement, a capital lease affects your balance sheet, income statement, and cash flow, impacting your company’s overall financial position. While it provides a way to acquire important assets without substantial capital outlay, it also introduces a liability which can potentially impact how lenders and investors view your business. 

For these reasons, it is important to evaluate the nuances of a lease agreement and its impact in the aggregate before signing any pertinent document. If you’re looking for trustworthy lease accounting solutions for your business, Black Owl Systems is the best solution. Our expertise will ensure your capital leases are accurately recorded and maintained, allowing you to execute lease disclosures accurately and consistently.

No matter if you’re in need of reporting, financial analysis, or quality accounting solutions, we will have the tools to assist your business. Please visit our website today to learn more about how we can help improve your lease accounting business!