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Tata Capital > Blog > Equipment Lease > Operating Lease vs Finance Lease: Differences, Pros & Cons

Equipment Lease

Operating Lease vs Finance Lease: Differences, Pros & Cons

Operating Lease vs Finance Lease: Differences, Pros & Cons

You want to scale your business, and your company plans to expand its production facilities. But you are not too sure about the market demand and economic viability of investing in a new production unit. Or you want to buy equipment without disturbing your cash flow or taking a loan. 

Leasing would be the ideal solution in such circumstances because there are many leasing structures to suit the different needs of emerging businesses.

What is an Operating Lease?

You could take manufacturing equipment on lease. You pay the lessor a certain amount for a short period based on a lease agreement/contract. At the end of the specified period, the ownership of the equipment remains with the lessor.

What is a Finance Lease?

You could opt to pay for using manufacturing equipment for an extended period by signing a lease agreement/contract. However, at the end of the specified period, you can buy the equipment at a price lower than the actual market value. 

These two scenarios illustrate two different leasing options – Operating lease and Capital or Finance lease. 

Which one is right for you? Read on to find out.

Operating lease

When you sign a rent agreement/contract to lease an asset, you agree to pay lease rentals for the lease tenure. Generally, the lease period is less than the usable period of the asset. It is also known as a Service lease.

Wet vs Dry Operating Lease

There are two different kinds of operating leases. In a wet lease, the lessor provides essential operating services such as personnel, insurance and maintenance services along with leasing. In contrast, only the equipment is leased out in cases of a dry lease. 

Tata Capital offers equipment on lease in sectors like healthcare, medical technology, vehicles, etc. Avail of the best offers that will enable you to scale your business without burdening stressed capital reserves.

Advantages of Operating Lease

In this sort of arrangement, tax deductions are allowed on rent payments. The lessor bears maintenance and repair costs. Though there is no asset ownership, the lessee can upgrade or replace the asset to the latest model if so desired upon the expiry of the lease.

Leasing equipment is prudent since companies won’t get stuck with outdated equipment. More importantly, the cash flow remains unstressed and smooth. 

However, you must keep in mind that the leased asset does not add to the company’s equity. Since its ownership reverts to the lessor at the end of the term, it remains off the balance sheet.

Capital or Financing Lease

When a lease is taken based on a long-term loan agreement/contract, you have an opportunity to buy the asset at the end of the specified time at a mutually agreed fair price. Lessors cannot generally cancel such leases, and the asset cannot be sub-leased to third parties. The risks, maintenance and insurance are to be handled by the lessee.

Types of Capital Lease

Direct Lease

As the name suggests, the manufacturer of the asset or leasing firms lease the asset directly to the lessee.

Sale and Lease Back 

In this arrangement, an asset is sold by firm A to a lessor B. Lessor B, in turn, leases the asset back to firm A that had sold the said asset. Insurance companies and finance companies commonly utilise this type of lease. The lessee, firm A, earns money from the sale while continuing to use the asset sold.

Leverage Lease

Tata Capital offers this popular option to its customers, wherein the lessor borrows money from a lending partner to buy the asset. Then the lessor leases the said asset to a lessee who pays the lease rental. The lessor repays the loan to the lending partner.

Heavy equipment integral to businesses such as industrial ovens, machines for agricultural use, etc., often requires considerable capital investment. Companies can invest in such equipment without worrying about limited capital to fund it upfront with a leveraged lease.

Lending institutions like Tata Capital support entrepreneurs, especially in the post-COVID slump, through equipment financing in line with this type of lease.

Advantages of Financing Lease

The Financing Lease is advantageous as the lessee becomes the asset owner at a bargain price. Lessors can claim depreciation of the asset and reduce taxable income. Businesses can also improve tax savings as lease rentals and interest paid are accounted as an expenditure. 

However, it is essential to remember that since it is a loan agreement against the asset, if there are glitches in paying interest, a credit score is affected negatively. In a worst-case scenario, non-payment could lead to repossession of the asset. There is also the risk of the leased asset becoming obsolete due to technological leaps, resulting in the lessee getting stuck with an outdated asset.

Making informed choices

A lease could give a new lease of life to your business, but you have to make an informed choice regarding the type of lease. Experts at Tata Capital Corporate will help you arrive at a prudent decision, considering your requirements and convenience. Reach out to us to know more.

Key Differences Between Operating Lease and Finance Lease

FactorFinancial LeaseOperating Lease
MeaningLong-term agreement where the asset is used for most of its useful lifeShort-term agreement to use an asset for a limited period
DurationUsually long-termUsually short-term
OwnershipOwnership passes to the lessee at the end of the leaseOwnership stays with the lessor
Risk of obsolescenceBorne by the lesseeBorne by the lessor
MaintenanceLessee is responsible for upkeep and repairsLessor handles maintenance
CancellationCan be cancelled only under special conditionsCan usually be cancelled easily
Purchase optionLessee gets an option to buy the assetNo option to buy the asset

Accounting & Tax Implications: Operating Lease vs Finance Lease

In India, lease accounting has changed with Ind AS 116, which follows IFRS 16. Under this rule, businesses must show almost all leases on their balance sheet. This means the old difference between operating lease and finance lease no longer matters much for accounting.

Now, companies record:

a Right-of-Use asset (the right to use the asset), and

a lease liability (future lease payments)

However, there are exceptions. Short-term leases and low-value assets can still be treated like operating leases, where rent is shown as an expense.

Earlier rules like AS 19 and Ind AS 17 required leases to be classified as operating or finance. This depended on factors such as lease length, ownership transfer, and total payment value.

For tax purposes, the difference still matters. Under the Income Tax Act, depreciation, interest deductions, and lease rent treatment may change based on the lease type. In some cases, the lessor claims depreciation; in others, the lessee can claim interest and depreciation.

Startups and small businesses must review lease terms carefully. Even though accounting is simpler now, tax impact, long-term payments, and risks can differ between operating and finance leases.

How to Choose Between Operating Lease and Finance Lease

Selecting between an operating lease and a finance lease depends on how long you need the asset, your cash flow, and your business plans.

A financial lease works better when the asset is important to daily operations and will be used for a long time. Consider it if you want full control over the asset and may want to own it in the future. Finance leases usually have higher monthly payments, so they are better for businesses with stable and predictable cash flow. They can also offer tax benefits, as interest and depreciation may be claimed in some cases. This option is common for machinery, heavy equipment, or long-term vehicles.

An operating lease is a better choice when flexibility is more important. It suits assets needed for a short period or those that need frequent upgrades. Monthly payments are usually lower, helping you save cash. Maintenance and repair responsibilities often stay with the lessor, reducing effort and risk. This lease type works well in industries where technology or equipment becomes outdated quickly, such as IT or fleet vehicles.

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FAQs

What is the main difference between an operating lease and a finance lease?

 

A financial lease is for long-term use with ownership benefits, while an operating lease is short-term, where the asset is rented and returned after use.

How are operating and finance leases shown on the balance sheet?

 

Under Ind AS 116, most leases are entered in the balance sheet as a right-of-use asset and a lease liability.

Are lease payments tax-deductible under both types of lease?

 

Yes, lease payments are generally tax-deductible, but deductions differ based on lease type, ownership, depreciation, and interest treatment.

Can ownership transfer to the lessee in a finance lease?

 

Yes, a finance lease usually allows the lessee to buy or own the asset at the end of the lease term.

Which lease is best for short-term equipment use in India?

 

An operating lease is better for short-term use, as it offers flexibility, lower commitment, and easier upgrades.

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