Financial and Strategic Management

What is Lease Finance?

A lease represents a contractual arrangement whereby the lessor grants the lessee the right to use an asset in return for periodic lease rental payments. While leasing of land, buildings, and animals has been known from times immemorial, the leasing of industrial types of equipment is a relatively recent phenomenon, particularly on the Indian scene.

There are two broad types of leases: finance lease and operating lease.

Finance Lease

A finance lease or capital lease is essentially a form of borrowing. Its salient features are:

  1. It is an intermediate-term to a long-term non-cancellable arrangement. During the initial lease period, referred to as the ‘primary lease period’. Which is usually three years or five years or eight years, the lease cannot be canceled.
  2. The lease is more or less fully amortized during the primary lease period. This means that during this period, the lessor recovers, through the lease rentals, his investment in the equipment along with an acceptable rate of return. Thus, a finance lease transfers substantially all the risks and rewards incident to ownership to the lessee.
  3. The lessee is responsible for maintenance, insurance, and taxes.
  4. The lessee usually enjoys the option of renewing the lease for further periods at substantially reduced lease rentals.

Operating Lease

An operating lease can be defined as any lease other than a finance lease. The salient features of an operating lease are:

  1. The lease term is significantly less than the economic life of the equipment.
  2. The lessee enjoys the right to terminate the lease at a short notice without any significant penalty.
  3. The lessor usually provides the operating know-how and the related services and undertakes the responsibility of ensuring and maintaining the equipment. Such an operating lease is called a ‘wet lease’. An operating lease where the lessee bears the costs of insuring and maintaining the leased equipment is called a ‘dry lease’.

From the above features of an operating lease, it is evident that this form of a lease does not result in a substantial transfer of the risks and rewards of ownership from the lessor to the lessee. The lessor structuring an operating lease transaction has to depend upon multiple leases or on the realization of a substantial resale value (on expiry of the first lease) to recover the investment cost plus a reasonable rate of return thereon. Therefore, specializing in operating lease calls for in-depth knowledge of the types of equipment and the secondary (resale) market for such types of equipment. Of course, the prerequisite is the existence of a resale market. Given the fact that the resale market for most of the used capital types of equipment in our country lacks breadth, operating leases are not in popular use. In recent years there have been attempts to structure car lease and computer lease transactions in the operating lease format.

The key features of lease finance in India:
– Most leases in India are finance leases not operating leases
– Lease finance is available for identifiable performing assets
– Lease finance is available in a small volume
– There is a great deal of flexibility in structuring lease finance
– Lease of immovable assets is not possible by banks
– Lease tenors up to eight years is available

About the author

Shreya Kushwaha

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