Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductible payments. The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets. The relationship between the tenant and the landlord is called a tenancy, and can be for a fixed or an indefinite period of time (called the term of the lease). The consideration for the lease is called rent. Under normal circumstances, an owner of property is at liberty to do what they want with their property, including destroys it or hand over possession of the property to a tenant. Similar principles apply to real property as well as to personal property, though the terminology would be different. Similar principles apply to sub-leasing, that is the leasing by a tenant in possession to a sub-tenant. The right to sub-lease can be expressly prohibited by the main lease.
Term of the lease may be fixed, periodic or of indefinite duration. If it is for a specified period of time, the term ends automatically when the period expires, and no notice needs to be given, in the absence of legal requirements. It is common for a lease to be extended on a "holding over" basis, which normally converts the tenancy to a periodic tenancy on a month by month basis.
Advantages
For businesses, leasing property may have significant financial benefits:
Leasing is less capital-intensive than purchasing, so if a business has constraints on its capital, it can grow more rapidly by leasing property than it could by purchasing the property outright.
Capital assets may fluctuate in value. Leasing shifts risks to the lessor, but if the property market has shown steady growth over time, a business that depends on leased property is sacrificing capital gains.
Because of investments which are done with leasing, new businesses are formed. Furthermore, unemployment in that country is decreased.
Leasing may provide more flexibility to a business which expects to grow or move in the relatively short term, because a lessee is not usually obliged to renew a lease at the end of its term.
In some cases a lease may be the only practical option; such as for a small business that wishes to locate in a large office building within tight location parameters.
Depreciation of capital assets has different tax and financial reporting treatment from ordinary business expenses. Lease payments are considered expenses, which can be set off against revenue when calculating taxable profit at the end of the relevant tax accounting period.
Disadvantages
For businesses, leasing property may have significant drawbacks:
A net lease may shift some or all of the maintenance costs onto the tenant.
If circumstances dictate that a business must change its operations significantly, it may be expensive or otherwise difficult to terminate a lease before the end of the term. In some cases, a business may be able to sublet property no longer required, but this may not recoup the costs of the original lease, and, in any event, usually requires the consent of the original lessor. Tactical legal considerations usually make it expedient for lessees to default on their leases. The loss of book value is small and any litigation can usually be settled on advantageous terms. This is an improvement on the position for those companies owning their own property. Although it can be easier for a business to sell property if it has the time, forced sales frequently realize lower prices and can seriously affect book value.
If the business is successful, lessor may demand higher rental payments when leases come up for renewal. If the value of the business is tied to the use of that particular property, the lessor has a significant advantage over the lessee in negotiations.
Types of Lease:
1 - Finance Lease
2 - Operating Lease
A finance lease or capital lease is a commercial arrangement where:
the lessee (customer or borrower) will select an asset (egg: equipment, vehicle, software);
the lessor (finance company) will purchase that asset;
the lessee will have use of that asset during the lease;
the lessee will pay a series of rentals or installments for the use of that asset;
the lessor will recover a large part or all of the cost of the asset plus earn interest from the rentals paid by the lessee;
The lessee has the option to acquire ownership of the asset (e.g. paying the last rental, or bargain option purchase price).
The finance company is the legal owner of the asset during duration of the lease.
However the lessee has control over the asset providing them the benefits and risks of (economic) ownership.
An operating lease:
Is a lease whose term is short compared to the useful life of the asset or piece of equipment (an airliner, a ship, etc.) being leased.
An operating lease is commonly used to acquire equipment on a relatively short-term basis. Thus, for example, an aircraft which has an economic life of 25 years may be leased to an airline for 5 years on an operating lease.
In the context of cars and other passenger vehicles, under an operating lease the lessor leases the vehicle to the lessee for a fixed monthly amount, and also assumes the residual value risk of the vehicle.
This provides a way to lease a vehicle where the cost of the vehicle is known in advance - however, operating leases can be an expensive option as there is a risk premium priced into the monthly payments.
Comparing Finance Lease with Operating lease
In a finance lease the lessee has use of the asset over most of its economic life and beyond (generally by making small 'peppercorn' payments at the end of the lease term).
In an operating lease the lessee only uses the asset for some of the asset's life.
In a finance lease the lessor will recover all or most of the cost of the equipment from the rentals paid by the lessee.
In an operating lease the lessor will have a substantial investment or residual value on completion of the lease.
In a finance lease the lessee has the benefits and risks of economic ownership of the asset (e.g. risk of obsolescence, paying for maintenance, claiming capital allowances/depreciation).
In an operating lease the lessor has the benefits and risks of owning the asset
Impact on accounting
Since a finance lease is capitalized, both assets and liabilities (current and long-term ones) in the balance sheet increase. As a consequence, working capital decreases, but the debt/equity ratio increases, creating additional leverage.
Finance lease expenses are allocated between interest expense and principal value much like a bond or loan; therefore, in a statement of cash flows, part of the lease payments are reported under operating cash flow but part under financing cash flow. Therefore, operating cash flow increases.
Under operating lease conditions, lease obligations are not recognized; therefore, leverage ratios are understated and ratios of return (ROE and ROA) are overstated.
A leveraged lease is a lease in which the lessor puts up some of the money required to purchase the asset and borrows the rest from a lender. The lender is given a senior secured interest on the asset and an assignment of the lease and lease payments. The lessee makes payments to the lessor, who makes payments to the lender.
The term may also refer to a lease agreement wherein the lessor, by borrowing funds from a lending institution, finances the purchase of the asset being leased.
The lessor pays the lending institution back by way of the lease payments received from the lessee. Under the loan agreement, the lender has rights to the asset and the lease payments if the lessor defaults.
In this type of lease, the lessor provides an equity portion (often 20% to 50%) of the equipment cost and lenders provide the balance on a nonrecourse debt basis. The lessor receives the tax benefits of ownership.
A lease contract is an agreement where the owner conveys to the user the right to use an asset in return for a number of specified payments over an agreed period of time.
Conditional Sales Agreement:
Conditional sales agreement exists if one of the following occurs:
The lessee automatically acquires ownership at some point
The lessee is required to buy the asset at some point or guarantee that the lessor gets a certain value for it
The lessee has the right to buy the asset at some point for substantially less than the likely fair market value
The lessee has the right to buy the asset at a price that would cause a reasonable person to conclude that they will buy it.
Financial leases are included on the balance sheet of the lessee.
Present value of all lease payments is recorded on the right-hand side of the Balance Sheet
The same amount is recorded as an asset on the left-hand side of the balance.
Operating leases are off-balance-sheet financing for the lessee (included only in the notes to the financial statements).
Lease versus Buy:
Leasing is an alternative means of obtaining the use of an asset.
There are four main differences in the cash flows for a company that leases an asset instead of buying it:
It does not have to pay for the asset up front
It does not get to sell the asset when it is finished with it, if it is an operating lease, or if title is not transferred through a financial lease
It makes regular lease payments. If the lease is an operating lease, then the full amount of the lease payments is tax deductible; only the interest portion is deductible for capital leases
Operating leases are not depreciated.
IRR of Leasing Analysis
Estimate incremental cash flows that result from leasing
Solve for the discount rate (IRR) that equates the incremental cash flows with the initial value of the asset. (This is the after-tax IRR or cost of leasing)
If IRR of leasing > after-tax cost of borrowing (borrow and buy the asset)
If IRR of leasing < after-tax cost of borrowing (lease the asset)
NPV of Leasing Analysis
Estimate incremental cash flows that result from leasing
Calculate NPV using after-tax cost of borrowing as the discount rate.
If NPV of leasing is - (borrow and buy the asset)
If NPV of leasing is + after-tax cost of borrowing (lease the asset)
Motivation for Leasing:
Cheaper financing (which party can make better use of the CCA tax shield/)
Reduce the risks of asset ownership
Implicit interest rates
Maintenance
Convenience
Flexibility
Capital budgeting restrictions
Financial statement effects
Conclusion:
That firms can gain the use of assets through leasing rather than outright ownership
The general differences between operating and financial leases
Evaluation of a potential lease decision using discounted cash flow analysis
The various reasons firms might have for entering into lease arrangements
Factoring
Definition:
Factoring is defined as 'a continuing legal relationship between a financial institution (the factor) and a business concern (the client), selling goods or providing services to trade customers (the customers) on open account basis whereby the Factor purchases the client's book debts (accounts receivables) either with or without recourse to the client and in relation thereto controls the credit extended to customers and administers the sales ledgers'.
It is the outright purchase of credit approved accounts receivables with the factor assuming bad debt losses.
Factoring provides sales accounting service, use of finance and protection against bad debts.
Factoring is a process of invoice discounting by which a capital market agency purchases all trade debts and offers resources against them.
Different kinds of factoring services:
Credit Information: Factors provide credit intelligence to their client and supply periodic information with various customer-wise analysis.
Credit Protection: Some factors also insure against bad debts and provide without recourse financing.
Invoice Discounting or Financing: Factors advance 75% to 80% against the invoice of their clients. The clients mark a copy of the invoice to the factors as and when they raise the invoice on their customers.
TYPES OF FACTORING:
Recourse Factoring
Non-recourse Factoring
Maturity Factoring
Cross-border Factoring
RECOURSE FACTORING:
Up to 75% to 85% of the Invoice Receivable is factored.
Interest is charged from the date of advance to the date of collection.
Factor purchases Receivables on the condition that loss arising on account of non-recovery will be borne by the Client.
Credit Risk is with the Client.
Factor does not participate in the credit sanction process.
In India, factoring is done with recourse.
NON-RECOURSE FACTORING:
Factor purchases Receivables on the condition that the Factor has no recourse to the Client, if the debt turns out to be non-recoverable.
Credit risk is with the Factor.
Higher commission is charged.
Factor participates in credit sanction process and approves credit limit given by the Client to the Customer.
MATURITY FACTORING:
Factor does not make any advance payment to the Client.
Pays on guaranteed payment date or on collection of Receivables.
Guaranteed payment date is usually fixed taking into account previous collection experience of the Client.
Nominal Commission is charged.
No risk to Factor.
CROSS - BORDER FACTORING:
It is similar to domestic factoring except that there are four parties, viz.,
a) Exporter,
b) Export Factor,
c) Import Factor, and
d) Importer.
It is also called two-factor system of factoring.
Exporter (Client) enters into factoring arrangement with Export Factor in his country and assigns to him export receivables.
Export Factor enters into arrangement with Import Factor and has arrangement for credit evaluation & collection of payment for an agreed fee.
Notation is made on the invoice that importer has to make payment to the Import Factor.
Import Factor collects payment and remits to Export Factor who passes on the proceeds to the Exporter after adjusting his advance, if any.
Where foreign currency is involved, Factor covers exchange risk also.
Services rendered by factor:
Factor evaluated creditworthiness of the customer (buyer of goods)
Factor fixes limits for the client (seller) which is an aggregation of the limits fixed for each of the customer (buyer).
Client sells goods/services.
Client assigns the debt in favour of the factor
Client notifies on the invoice a direction to the customer to pay the invoice value of the factor.
Client forwards invoice/copy to factor along with receipted delivery challans.
Factor provides credit to client to the extent of 80% of the invoice value and also notifies to the customer
Factor periodically follows with the customer
When the customer pays the amount of the invoice the balance of 20% of the invoice value is passed to the client recovering necessary interest and other charges.
If the customer does not pay, the factor takes recourse to the client
What is the use of Factoring?
The seller's invoices into cash, which means that the seller can have instant access to its earnings. Sellers don't have to wait for the usual long period to get paid by their buyers. The seller will, therefore have a healthier cash flow, which will accelerate the growth.
The benefits to the seller are multifold as listed below:
The seller gets 100% protection against bad debts.
The amount of money the seller can get from FACTOR automatically adjusts to the level of turnover.
Hence, FACTOR is able to provide a growing business with a growing finance resource.
The sales ledger maintenance and the credit control function is carried out by FACTOR, which saves time and money for the seller.
FACTOR collects money due from the customers.
How will the seller be kept informed of payments made by its buyer?
FACTOR will send the seller a monthly statement of accounts. This statement will show credits for debts purchased, a debit for credit notes issued and the amount of cash drawn, among other details.
Would a seller lose direct control of his sales if he uses Factoring?
FACTOR will not only keep the seller regularly informed of the position of his individual customer's account but will also consult him closely on collection procedures.
Forfaiting
The Forfaiting owes its origin to a French term 'forfeit' which means to forfeit (or surrender) one's rights on something to some one else.
Under this mode of export finance, then exporter forfeits his rights to the future receivables and the forfeiter loses recourse to the exporter in the event of non-payment by the importer.
CHARACTERISTICS OF FORFAITING:
Converts Deferred Payment Exports into cash transactions, providing liquidity and cash flow to Exporter.
Absolves Exporter from Cross-border political or conversion risk associated with Export Receivables.
Finance available up to 100% (as against 75-80% under conventional credit) without recourse.
Acts as additional source of funding and hence does not have impact on Exporter's borrowing limits. It does not reflect as debt in Exporter's Balance Sheet.
Provides Fixed Rate Finance and hence risk of interest rate fluctuation does not arise.
Exporter is freed from credit administration.
Provides long term credit unlike other forms of bank credit.
Saves on cost as ECGC Cover is eliminated.
Simple Documentation as finance is available against bills.
Forfeit financer is responsible for each of the Exporter's trade transactions. Hence, no need to commit all of his business or significant part of business.
Forfeit transactions are confidential.
COSTS INVOLVED IN FORFAITING;
Commitment Fee:- Payable to Forfeiter by Exporter in consideration of forfeiting services.
Commission: - Ranges from 0.5% to 1.5% per annum.
Discount Fee: - Discount rate based on LIBOR for the period concerned.
Documentation Fee: - where elaborate legal formalities are involved.
Service Charges: - payable to Exim Bank.
Methodology:
It is a trade finance extended by a forfeiter to an exporter/seller for an export/sale transaction involving deferred payment terms over a long period at a firm rate of discount.
Forfaiting is generally extended for export of capital goods, commodities and services where the importer insists on supplies on credit terms.
The exporter has recourse to Forfaiting usually in cases where the credit is extended for long durations but there is no prohibition for extending the facility where the credits are maturing in periods less than one year.
Credits for commodities or consumer goods are generally for shorter duration within one year. Forfaiting services are extended in such cases as well.
Mechanism:
There are five parties in a transaction of Forfaiting. These are :
Exporter
Exporter's bank
Importer
Importer's bank and
Forfeiter
The exporter and importer negotiate the proposed export sale contract. These are the preliminary discussions.
Based on these discussions the exporter approaches the forfeiter to ascertain the terms for forfeiting.
The forfeiter collects from exporter all the relevant details of the proposed transaction, viz., details about the importer, supply and credit terms, documentation, etc., in order to ascertain the country risk and credit risk involved in the transaction..
Depending upon the nature and extent of these risks the forfeiter quotes the discount rate.
The exporter has now to take care that the discount rate is reasonable and would be acceptable to his buyer.
He will then quote a contract price to the overseas buyer by loading the discount rate, commitment fee, etc., on the sale price of the goods to be exported.
If the deals go through, the exporter and forfaiter sign a contract.
Export takes place against documents guaranteed by the importer's bank.
The exporter discounts the bill with the forfaiter and the forfaiter presents the same to the importer for payment on due date or even can sell it in secondary market.
Documentation and cost:
Forfaiting transaction is usually covered either by a promissory note or bill of exchange. In either case it has to be guaranteed by a bank or, bill of exchange may be 'avalled' by the importer' bank.
The 'Aval' is an endorsement made on bill of exchange or promissory note by the guaranteeing bank by writing 'per aval' on these documents under proper authentication.
The forfeiting cost for a transaction will be in the form of 'commitment fee', 'discount fee' and 'documentation fee'.
Mechanism- a case:
Export-Import Bank of India, (EXIM Bank) has started with a scheme to the Indian exporters by working out an intermediary between the exporter and the forfeiter.
The scheme takes place in the following stages:
1. Negotiations being between exporter and importer with regard to contract price, period of credit, rate of interest, etc.
2. Exporter approaches EXIM Bank with all the relevant details for an indicative discount quote.
3. EXIM Bank approaches an overseas forfeiter; obtain the quote and gets back to exporter with the offer.
4. Exporter and importer finalize the term of contract. All costs levied by a forfeiter are to be transferred to the overseas buyer. As such discount and other charges are loaded in the basic contract value.
5. Exporter approaches EXIM Bank and it in turn the forfeiter for the firm quote. The exporter confirms the acceptance of the arrangement.
6. Export takes place - shipping documents along with bill of exchange, promissory note have to be in the prescribed format.
7. Importer's bank delivers shipping documents to importer against acceptance of bill of exchange or on receipt of promissory note from the importer as the case may be and send these to exporter's bank with its guarantee.
8. Exporter's bank gets bill of exchange/promissory note endorsed with the words 'Without Recourse' from the exporter and present the document(s) to EXIM Bank who in turn send it to the forfeiter.
9. Forfeiter discounts the documents at the pre-determined rate and passes on funds to EXIM Bank for onward disbursement to exporter's bank nostro account of exporter's bank.
10. Exporter's bank credits the amount to the exporter.
11. Forfaiter presents the documents on due date to the importer's bank and receives the dues.
12. Exporter's bank recovers the amount from the importer.
DIFFERENCE BETWEEN FACTORING AND FORFAITING:
Factoring
1. Suitable for ongoing open account sales, not backed by LC or accepted bills or exchange.
2. Usually provides financing for short-term credit period of up to 180 days.
3. Requires continuous arrangements between factor and client, whereby all sales are routed through the factor.
4. Factor assumes responsibility for collection, helps client to reduce his own overheads.
5. Separate charges are applied for
- financing
- Collection
- Administration
- credit protection and
- Provision of information.
6. Only additional charges are commitment fee, if firm commitment is required prior to draw down during delivery period.
7. Financing can be with or without recourse; the credit protection collection and administration services may also be provided without financing.
8. Usually available for export receivables only denominated in any freely convertible currency.
9. Factor can assist with completing import formalities in the buyer's country and provide ongoing contract with buyers.
Forfeiting
1. Oriented towards single transactions backed by LC or bank guarantee.
2. Financing is usually for medium to long-term credit periods from 180 days upto 7 years though shorter credit of 30-180 days is also available for large transactions
3. Seller need not route or commit other business to the forfaiter. Deals are concluded transaction-wise.
4. Forfeiter's responsibility extends to collection of forfeited debt only. Existing financing lines remains unaffected.
5. Single discount charges is applied which depend on
- Guaranteeing bank and country risk,
- Credit period involved and
- Currency of debt.
6. Service is available for domestic and export receivables.
7. It is always 'without recourse' and essentially a financing product.
8. Usually no restriction on minimum size of transactions that can be covered by factoring.
9. Forfaiting will accept only clean documentation in conformity with all regulations in the exporting/importing countries
