I often get asked the question….is it better to buy equipment outright or to lease it?
Finally a guide which helps you explore your options to arrive at the right decision for your business.
The decision to buy or lease equipment for your business depends upon the nature of your particular business.
If you have the money available, and the item is really necessary to your business operations, then it will usually benefit you to buy it outright. If there is no way you can find the finance (that is, you have no money or the item is very expensive and you do not want to tie up large amounts of cash) then you will have to finance the purchase of the cash flow, which means leasing it.
If the options are not so clear-cut, then you have some thinking to do.
Ask these questions:
How often will I use the item?
If the item is only going to be used every now and then, there is no real point in buying one. It will lie around for most of the year unused and is therefore waste of your resources. So lease or hire the equipment when you require it.
What else could you do with the money?
Could you earn a better rate of return on the capital required for the item if you invested it in your business? Your business might be at the stage where spare cash injected back in as working capital will give you a far better rate of return than tying up the money in equipment. For example, could you get better use out of the money by spending it on marketing or exploring new opportunities? So in this case, it might pay to lease.
Consider your working capital
If you want to buy the item, don’t do so at the risk of not being able to meet your bills. Only surplus cash – and then only if it really is “surplus”, not just temporarily in your bank account. You should work this out through a cash flow forecast that takes into account your future income and expenditure.
The decision to buy or lease will affect your net profit differently. Below are the calculated differences based on equipment purchase price of $20,000:
OPTION 1 – (LEASE)
If you lease, the equipment might cost you around $500 per month, or $6000 for the year which can be claimed as a business expense as it’s a lease not a capital purchase. By claiming $6,000 as expenses, you’ll pay LESS tax of $1,800 at a company tax rate of 30%. So you could say that you’ve spent $6,000 and ‘save’ $1,800, giving net cash out for the business of $4,200 for that tax year.
OPTION 2 – (BUY)
If you buy the equipment, the total cost of $20,000 cannot be claimed as a business expense as the equipment is now considered to be an asset. Let’s say you depreciate the equipment at 20% per year. This means you can claim $4,000 as an expense for the year ($20,000 x 20% = $4,000) which gives you a tax ‘saving’ of $1,200 (30% of $4,000). So your net cash out is $18,800 for that tax year ($20,000 less $1,200).
But what about year 2,3 & 4
In Option 1 – (Lease) you’d still have to pay $6,000 in lease costs for the 2nd, 3rd & 4th year.
In Option 2 – (Buy) you have no further cash to pay (the equipment is now yours), but you can still claim depreciation of $4,000 straight line method
This comparison shows that whilst you might have gained a slightly better cash flow situation in year one, the lease option becomes far less attractive in subsequent years. So as a rule of thumb, if you lease equipment you will spend less cash in the first year or two and this is a viable alternative if you do not have the cash. However, long term it’s much better to buy equipment outright provided you can safely ride out the initial heavy cash commitment, and it is going to be a productive piece of equipment over time.
|Year 1||Year 2||Year 3||Year 4||Year 1||Year 2||Year 3||Year 4|
|Net Cash Out||$4,000||$4,000||$4,000||$4,000||$18,800||Nil||Nil||Nil|
|Accumulated Net Expense||$4,000||$8,000||$12,000||$16,000||$18,800||$17,600||$16,400||$15,200|
As the table shows, leasing becomes more expensive than buying from Year 4, with accumulative net expense totalling $16,000 in that year and continuing to increase by $4,000 each year. Compare this with the accumulative net expense for buying in Year 4 of $15,200, with this amount decreasing by $1,200 each year. Note that a straight-line depreciation rate of 20% was used for the equipment. This rate suggests that the equipment will last at least five years.
Some further considerations
Over the longer term, it is good business practice to budget for capital item purchases or replacements. This is particularly true of technology equipment that is likely to be obsolete within five or six years. Before you make any final decision about buying or leasing equipment, you should also talk to your accountant about the particular circumstances of your business. In addition tax laws can change. Advice from your accountant will help you make the best decision for your business.