Finance Lease

Saturday 17th February | 9 minute read

A finance lease is a financial arrangement where a leasing company grants a business the operational control of an asset for a set period.

Do you need new vehicles, plant, equipment or machinery for your business but cannot afford to buy it outright? Asset finance allows your company to acquire necessary assets by spreading the cost over time, preserving your cash flow.

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2024 Finance Leasing Guide

A Finance Lease (capital lease) is a financial arrangement enabling businesses to use vehicles, plant, machinery, or equipment without initial ownership.

This lease involves the lessee making regular payments to the lessor, who purchases the asset, covering its use, interest, and added costs over a fixed period. At the end of the lease, the lessee may have options to buy the asset, renew the lease, or return it, sharing both the economic benefits and risks during the lease term. Finance leases are attractive for businesses needing expensive assets without tying up capital, offering flexibility and potential tax benefits. However, they come with disadvantages such as higher long-term costs, maintenance responsibilities, and the risk of obsolescence, requiring businesses to weigh these against their operational and financial goals.

What is a Finance Lease?

A Finance Lease is a commercial financial arrangement where a business uses vehicles, plant, machinery or equipment without owning it outright. In this type of lease, the leasing company (lessor) purchases the asset and then leases it to the business (lessee) for a fixed period.

Characteristics of a finance lease:

  • Asset selection by the customer (lessee)
  • Asset purchased by the finance leasing company (lessor)
  • The lessee makes regular lease payments to the lessor for the asset's use
  • The lessor recoups the cost of the asset plus the interest
  • At the end of the term, and all monthly payments have been paid, the lessee will decide whether to take ownership of the asset.
  • It is a popular mechanism for businesses when contract hire is not suitable.

The key features of a finance lease are Regular Payments, Lease Term, and End of Lease Options.

Regular Payments

The lessee makes regular lease payments to the lessor, covering the cost of the asset's use over the lease term. These payments typically reflect the asset's total value, interest charges, and the lessor's profit margin.

Lease Term

The lease term usually aligns with the asset's expected useful life. At the end of the term, the lessee has several options, including extending the lease, returning the asset, or arranging for its sale.

Risk and Rewards

While the lessor retains legal ownership, the lessee assumes many risks and rewards of ownership, such as maintenance costs and the economic benefits of using the asset. This is a substantial difference from operating leases, where the lessor retains the risks and rewards associated with the asset.

End of Lease Options

At the end of a finance lease, the lessee might have the option to purchase the asset at a residual value, continue leasing it, or return it to the lessor. In some cases, the lessee may also arrange for the asset to be sold to a third party, with the lessee typically benefiting from any proceeds above the predetermined residual value.

Accounting Treatment

For accounting purposes, finance leases are treated as a form of capital lease, meaning the asset is recorded on the lessee’s balance sheet as if it were an asset owned by the lessee, reflecting both the asset's value and the lease obligation.

Finance leases are particularly attractive for businesses that require expensive equipment or vehicles but prefer not to tie up capital in outright purchases. They offer the flexibility to access and use the latest assets while managing cash flow effectively.

Example of Finance Lease

Let's consider a company that needs a new delivery truck for its operations but doesn't have the immediate capital to purchase one outright. The company enters a finance lease agreement for a delivery truck worth £50,000. Here's how the finance lease could be structured:

Lease Term. The company agrees to lease the truck for five years, aligning with the expected useful life of the vehicle.

Monthly Payments. Based on the interest rate and the lease term, the company agrees to make monthly payments of £1,000 to the leasing company. These payments cover the cost of the truck, interest, and the leasing company's profit margin.

Maintenance and Repairs. Under the finance lease terms, the company is responsible for all truck maintenance, repairs, and insurance costs during the lease period.

Ownership Option. At the end of the five-year lease term, the company want to purchase the truck for a residual value of £5,000. This buyout price is significantly less than the market value of the truck at that time, making it an attractive option for the company.

Economic Risks and Rewards. Throughout the lease term, the company enjoys the economic benefits of using the truck in its operations but also bears the risks associated with the truck's depreciation and any potential loss in value.

In this example, the finance lease allows the company to effectively utilise the delivery truck in its operations without a large upfront investment while providing a pathway to ownership at the end of the lease term.

What are the differences between leasing and financing?

Leasing is where you rent an asset for a set period, whereas financing an asset is where you pay monthly towards an asset to own it after a set time. Lease finance is where you initially lease the asset and then purchase the asset at the end of the term. 

What are the advantages of Finance Leasing?

The most important factors to users of a finance lease are Cost and Affordability, Lease Terms and Flexibility, Asset Ownership and Residual Value, Tax and Accounting Implications, and Maintenance and Upkeep Responsibilities. However, there are several more considerations.

Cost and Affordability of Finance Leases

The overall cost of the lease, including initial deposits, monthly payments, interest rates, and any end-of-lease fees, is a primary consideration. Users evaluate whether the lease is financially viable and aligns with their budget.

Lease Terms and Flexibility

The length of the lease term and the flexibility to adjust terms based on changing business needs are important. Users look for leases that offer the right balance between commitment period and adaptability.

Asset Ownership and Residual Value

Users are interested in the options available at the end of the lease term, such as purchasing the asset for its residual value, renewing the lease, or returning the asset. Understanding how the residual value is calculated and the potential for ownership is key.

Tax and Accounting Implications

The impact of the finance lease on the company's financial statements, including tax deductions for lease payments and how the lease is reported on the balance sheet, is significant for users.

Maintenance and Upkeep Responsibilities

Whether the responsibility for maintenance and repairs lies with the lessee or lessor will influence the attractiveness of a finance lease. Users consider the cost and logistics of asset upkeep.

Risk of Obsolescence

For technology or equipment that quickly becomes outdated, users assess the risk of being tied to an asset that may not meet future needs.

Early Termination Options and Penalties

The possibility of terminating the lease early and any associated costs or penalties is important, especially for businesses that may experience unpredictable changes.

Access to Up-to-Date Equipment

The ability to access or upgrade to newer models or technology at the end of the lease without significant additional investment is a crucial consideration for users looking to stay competitive.

Cash Flow Management

The impact of the lease on cash flow, including the benefit of not requiring a large upfront investment and how regular lease payments fit into ongoing financial planning, is vital.

Reputation and Reliability of the Lessor

Working with a reputable and reliable leasing company that offers transparent terms, good customer service, and support throughout the lease term is essential for users.

Evaluating these factors helps businesses and individuals make informed decisions that align with their financial capabilities, operational requirements, and long-term strategic goals when considering a Finance Lease.

How Does a Finance Lease Work?

A Finance Lease is a specific type of lease used primarily to acquire business assets, including vehicles and equipment. Here's a step-by-step overview of how a Finance Lease typically works:

Step 1: Needs Assessment

The business identifies its need for an asset but prefers leasing over purchasing to conserve cash flow or for other strategic reasons.

Step 2: Selection of Asset

The lessee (business) selects the asset it requires from a supplier.

Step 3: Choosing a Leasing Company

The business selects a leasing company (lessor) that agrees to purchase the asset and lease it back to the business.

Step 4: Lease Agreement

The lessor and lessee agree on the lease terms, including the lease duration, monthly lease payments, interest rate, and responsibilities for maintenance and insurance. The agreement will also outline the options available at the end of the lease term.

Step 5: Purchase of the Asset

The leasing company purchases the asset from the supplier. Legally, the lessor owns the asset.

Step 6: Lease Payments

The business starts using the asset and makes regular lease payments to the leasing company for the duration of the lease agreement. These payments cover using the asset, interest, and other charges.

Step 7: Maintenance and Upkeep:

Depending on the lease agreement, the lessee may be responsible for the asset's maintenance, insurance, and upkeep throughout the lease term.

Step 8: End of Lease Options

As the lease term comes to an end, the business has several options, typically outlined in the lease agreement:

  • Purchase the Asset: The lessee can buy the asset at its residual value (a pre-agreed price).
  • Renew the Lease: The lease can be renewed with updated terms.
  • Return the Asset: The lessee returns the asset to the lessor, who may sell it in the secondary market.
  • Sell the Asset: In some cases, the lessee is able to sell the asset on behalf of the lessor to a third party and may benefit from any sale proceeds exceeding the residual value.
  • Completion or Renewal: The business either completes the lease by returning the asset, buying it, or renewing it under new terms, depending on the chosen end-of-lease option.

A Finance Lease allows businesses to use the latest assets without the full costs and responsibilities of ownership, providing flexibility and potential tax benefits. Still, it's important for businesses to carefully consider the terms and conditions to ensure they align with their financial and operational objectives.

What are the disadvantages of Finance Leasing?

While finance leases offer several benefits for businesses looking to use assets without outright purchasing them, there are also disadvantages to consider:

  • Total Cost Is Higher. 
    Over the life of the lease, the total payments made will exceed the cost of purchasing the asset outright, primarily due to interest and financing charges.
  • Long-term Commitment. 
    Finance leases typically involve a commitment for a significant period, which might not be ideal for businesses with changing needs or those who wish to upgrade their assets frequently.
  • No Ownership Until Buyout. 
    Lessees do not own the asset during the lease term and must decide at the end of the lease whether to purchase the asset, return it, or extend the lease. The total cost, including the buyout price, is larger than the asset's original purchase price.
  • Responsibility for Maintenance and Repairs. 
    Unlike other leasing options, in a finance lease, the lessee is often responsible for the asset's maintenance, repair, and insurance costs, which add up over time.
  • Limited Flexibility. 
    Once entered, finance lease agreements offer limited flexibility to modify terms or exit early without incurring penalties. This is restrictive for businesses facing unforeseen circumstances.
  • Asset Depreciation. 
    Lessees bear the risk of asset depreciation. If the asset's market value decreases more than anticipated, lessees may pay for an asset worth less than the lease payments.
  • Accounting and Tax Implications. 
    Finance leases are capitalised, meaning the asset and associated liability must be recorded on the company's balance sheet, which affects financial ratios and borrowing capacity. Also, while lease payments are tax-deductible, the tax benefits may differ from other financing methods.
  • Risk of Obsolescence
    For rapidly evolving technologies or equipment, there's a risk the leased asset may become obsolete before the lease term ends, leaving businesses with outdated tools.
  • End-of-Lease Costs
    Depending on the lease's terms, there could be significant costs at the end of the lease, such as balloon payments to purchase the asset, fees for excessive wear and tear, or costs associated with returning the asset.
  • Complexity
    Finance leases are complex financial instruments that require careful negotiation and understanding of the terms, including interest rates, lease duration, and end-of-lease options, adding to administrative overhead.

Final thoughts

In conclusion, finance leasing is a type of asset finance. It is a versatile and strategic financing solution for businesses aiming to utilise essential assets without the hefty initial investment of outright purchasing. Through our comprehensive Finance Leasing service, we cater to a broad spectrum of industries, offering customisable options for high-value assets ranging from plant and equipment to executive company car fleets. Available across the UK, our service is designed to meet the unique demands of your business, providing competitive rates and tailored terms. Whether expanding your operational capacity or upgrading your machinery, our finance lease options ensure you're able to plan, trade, and grow confidently. By choosing finance leasing, businesses enjoy the operational benefits of the latest assets while maintaining healthy cash flow and financial flexibility.

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