Lease Analysis & Negotiating a Lower Lease Payment!
Even though there is new guidance coming that will require all leases to be treated as “Capital” leases (booked on your balance sheet) you are currently still allowed to treat leases that qualify as “Operating” (booked like rent on income statement) which is sometimes preferred.
Depending upon your company’s financial statement presentation or what stage you are in, you may prefer to present your equipment leases as operating or capital. There are benefits and drawbacks to both methods.
If your company is trying to keep its balance sheet free of as many liabilities as possible, you may well prefer an operating lease which keeps the lease completely off the balance sheet and just expenses the lease payments as a rent type on the income statement.
If you are trying to build up your balance sheet with assets (the equipment is booked as an asset in a capital lease) while also building credit history for your business, you may prefer a capital lease. The additional benefit to a capital lease is that there is no equipment rental expense, but instead there is asset depreciation and interest expense both of which are not part of EBITDA (Earnings before interest, taxes, depreciation and amortization) an income metric that many business are measured upon. A capital lease pulls the expense of the equipment out of your EBITDA by definition.
In this article, we are referring primarily to equipment type leases whether they be for machinery & equipment, office equipment, vehicles or other equipment assets. This article should be read in conjunction with our lease test model that you can download from our site.
Under the current GAAP guidelines there are four tests that a lease agreement has to pass in order to be considered an operating rather than a capital lease:
Does the ownership of the leased property transfer to the lessee (your company) at the end of the lease term?
Does the lease contain a bargain purchase options, for example, a $1 buyout at the end of the lease?
Is the lease term 75% or more of the useful life of the equipment?
Is the present value of the minimum lease payments 90% or more of the current market price of the equipment?
If the answer to any of these questions is “yes”, the lease will have to be booked as a Capital Lease with the equipment value booked to fixed assets on your balance sheet offset by a note payable to the lessor on the liability side.
You can use our lease test model to run all of these tests on your lease based on the offered payment terms as well as other inputs. Click here for our lease test model. It also has a “lease vs. buy” section so you can see if it is cheaper for you to purchase the equipment via your bank or equipment line.
Strong negotiating tool with lessors:
I have been very successful in the past negotiating a materially lower lease payment by using this very lease test Excel model. I would explain to the equipment or leasing company that our company was not able to agree to any leases that did not pass as “Operating” as we needed to keep our balance free of “Capital” leases. I would then tell them how much lower the lease payment had to be in order not to trip test #4 above (the present value of lease payments test). Test number 4 is the best one to use for this purpose as there is a linear relationship to the lease rate factor (i.e. lease payment) to the percentage of the value of the equipment. Lessors typically build in a fair amount of profit in their leases so they almost always have plenty of room to negotiate the lease rate factor down substantially.
Please download our lease test model as it will pay for itself many times over and even with your first lease negotiation use.
So until GAAP dictates that all leases must be booked to your balance sheet (FASB ASU 842) with offsetting asset and liability entries, you can use this lease test model to your advantage for the best financial presentation that matches your needs. Even after the GAAP standards change, you can definitely still use our lease test model to see what lease rate factor the lessor is attempting to charge you and can use it to negotiate them well below their initial lease payment offer. You can always reach out to us on our feedback page with any questions or comments you have on this tool and we welcome you to do so!