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Buy or Lease: Benefits Galore

Shoud you buy or lease the business premises, that needed equipment or, today, even those extra employees? Those are questions that face every sign professional.

By Mark E. Battersby

Although the leasing of employees is a subject onto itself, virtually every owner and manager is faced with deciding whether buying or leasing is the best strategy for their sign business.

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  • The lease is a very old legal device. It was employed extensively centuries ago by the nobles and landed gentry to permit others to use parts of their real estate. The lease is still used extensively in connection with real estate -- often because property has not been available on any other basis.

    A major factor in the decision of whether your sign business should lease or not is flexibility. Ownership, after all, has become incidental in today's business climate. So long as the sign business is free to use equipment, it is not really necessary to own it.

    This is practical because under a lease, the sign business transfers all of the risks and uncertainties that go with owning equipment to the lessor. If the equipment becomes obsolete, the business can simply turn it in or have it upgraded. This has proven to be especially beneficial with computer systems that are changing so rapidly.

    Under a true equipment lease, the sign business (lessee) pays fixed monthly rental fees for the equipment for a mutually-agreed upon period of time. The lessee, or sign business, is not the owner of the equipment, but it may become the owner at the end of the lease term if that lease contains a "fair market value purchase option" clause. This provision allows the lessee, at least if the option is timely exercised, to acquire ownership of the leased equipment or property at the end of the lease's term for a previously-agreed upon amount.

    What can leasing offer the average sign business? The pros of equipment leasing are:

    1.) Fixed monthly payments that are generally immediately tax deductible as operating expenses;

    2.)Often a lower monthly payment;

    3.)Fewer documents to sign; and

    4.)At the end of the lease term, the equipment can be returned to the leasing company, a new lease entered into and new, updated equipment installed.

    Of course, leasing may be the only option if there is not sufficient cash available for the downpayment on an outright purchase. Remember, however, there is also a downside to leasing. On the other side of the equation, the cons of leasing are:

    1.)the sign business does not get the tax benefit of equipment ownership such as depreciation, tax credits and the like;

    2.) at the end of the lease term the sign business owner or manager must timely exercise any purchase option and pay the fair market value or other agreed-upon price for the equipment to obtain legal title;

    3.) if not timely exercised, the sign business may lose the right to purchase the equipment; and

    4.) with most leases, interest rates are usually higher than finance rates.

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    There are a variety of options available to any sign business wishing to lease needed equipment. Some businesses have sold a major part of their property and leased it back in order to shift the tax benefits from the business to the owner or investors. Others have induced financial institutions to build special-purpose property in return for a promise to lease this property for a long-term period of time.

    Leasing permits the sign operation to use property without the need for balance sheet recognition of either the property or the obligation to pay for it. This so-called "off-balance-sheet" financing has become important to many owners and managers since it doesn't usually affect the sign operation's ability to borrow in the future.

    There are two basic types of leases: the operating lease is a shorter-term lease and runs for a fraction of the useful life of the equipment. Services like maintenance and insurance often come with operating leases because the user tends to want to use the equipment, which is often high-tech and quickly becomes obsolete, for only a short period of time.

    With an operating lease, the lessor owns the equipment, takes the depreciation deduction and the lessee/business has no liability. For tax purposes, operating lease payments are treated as an operating expense, not a capital investment, and are deducted from operating revenues.

    A so-called "finance lease" on the other hand, is a lease that has an option at the end where the user can purchase the equipment at a bargain price. Although terms vary, purchasing the equipment at the end of the lease is often an option.

    The finance or capital lease is a full-payment or closed-end lease. It requires a sign operation to purchase the equipment at the end of the lease period at a percentage of the original value or for a nominal amount. The capital lease is usually designed for longer periods than an operating lease. It's similar to an installment sales contract.

    Under the finance or capital lease, equipment is capitalized on the balance sheet. The capital lease actually represents a type of loan in which ownership eventually passes to the lessee/business.

    In should be mentioned that many leases include insurance, maintenance, taxes and a variety of asset management services are usually available only to Fortune 500 companies. As far as service on leased equipment, there is no standard way to handle this. Some lessors automatically include service with others the owner or manager must negotiate the desired level of service to be provided.

    Although the Internal Revenue Service has a great deal to say about the tax treatment of every transaction labeled as a lease, it is actually the FINANCIAL ACCOUNTING STANDARDS BOARD (FASB), a body responsible for overseeing accounting standards, that creates the guidelines. According to FASB Statement 13, a capital lease needs to satisfy at least one of the following conditions in order to be classified as a capital lease:

    1) Title passes to lessee at the conclusion of the lease term.

    2) The lease contract includes a bargain purchase price.

    3) The lease term is at least 75 percent of the equipment's useful life.

    4) The present value of the minimum lease payment equals or exceeds 90 percent of the fair market value of the leased asset.

    Not so surprisingly, the ever-vigilant IRS has its own ideas about the lease or buy decision. In fact, so complex are the tax rules, that the IRS retains the right to restructure any transaction, regardless of what it is called, if the terms don't accurately reflect economic reality or that title.

    >From a financial perspective, the benefits of leasing are apparent: no down payment, low payments, cash-flow savings for the sign business and flexibility. In addition, many small sign businesses are attracted to leasing by the difficulty that they have in securing bank loans.

    In general, a sign business with a strong cash position and good financing options can often buy equipment outright or borrow to acquire equipment with a long operating life. If obsolescence is a concern, a short-term operating lease may provide the biggest advantage and the most flexibility.

    Naturally, if cash flow is an issue and the equipment must remain operable for longer periods, a long-term capital lease with a final residual payment will result in lower monthly payments plus a purchase option.

    Unfortunately, many owners and managers jump into leases without computing the long-term expense. If the lease is more affordable month-to-month than loan payments needed to acquire similar property, many owners and managers will go that route instead of buying.

    However, short-term savings may result in higher costs over the entire leasing period. This is especially true with a finance lease where the user can purchase the equipment at the end of the lease. The sign business may end up paying more in the long run. Obviously, it pays to determine any end of lease costs beforehand.

    Before entering into any lease, it is important to perform a lease analysis. A key part of the lease analysis is the review of the terms of the lease -- and an evaluation of the lessor(s). A review of the terms and conditions should include an examination of the lease by specialists in procurement, leasing, accounting, law and, of course, taxation. Remember, the financial difficulties experienced by a leasing company inevitably affect the sign operation leasing equipment from them.

    With interest rates at a 15-year low and finance companies and financial institutions offering bargain interest rates, now is the time to make that equipment purchase -- or lease equipment that may have been postponed. Most equipment manufacturers now offer leasing and financing. In most cases, their interest rates are lower than those offered by banks or traditional leasing companies. The decision of whether to lease or buy thus hinges on the financial situation of you and your sign business.

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