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Off-Balance Sheet Financing

Providers of off-balance sheet financing promote their product as the best thing since sliced bread. But is it?

First, off-balance sheet financing is just a fancy, albeit cooler sounding name for an operating lease. You get the use of a particular fixed asset (usually vehicles and equipment) over a specific period of time for a certain fee. With an off-balance sheet lease, however, you do not take possession of the asset at the end of the lease term. Instead, you turn the asset back in to the leasing company.

By contrast, you can also lease an asset which shows up on your balance sheet. With this lease, also known as a capital lease, you will pay a very small balance at the end of the lease (usually $1) and the asset becomes yours.

So the first critical decision you need to make before entering into an operating lease is “how long will I want the use of this asset?” If the answer is longer than the lease term being offered, it is likely you will be better off purchasing the asset or using a capital lease. If you would want to update or upgrade the asset after the lease term, the off-balance sheet could be a good choice.

The operative word is “could.” The two keys to an operating lease are the residual value of the asset at the end of the lease, and the effective equivalent interest rate.   Let’s start with residual value.

The higher the residual value, the less your lease payment. With an off-balance sheet lease, you are paying the leasing company for the difference between the price of the brand new equipment now and what that equipment will be worth at the end of the lease term.

Residuals are often stated in terms of percentage. For instance, a leasing company may quote a residual of 40% at the end of a three-year lease. If the equipment had a cost of $100,000, they think the equipment will have a market value of $40,000 after three years. That means they are only charging you for $60,000 plus interest over the three years you have the lease.

It pays to shop leasing companies because residuals vary from company to company on the exact same equipment. For instance, one company might use 40% while another company uses 45%. That would be a $5,000 savings (plus interest) over the lease term!

Next, check the equivalent interest rate. You can do this on a financial calculator by entering the $100,000 as present value, the residual value at future value, the number of lease payments, the amount of the payments, and then solving for the interest rate. If the rate is high, you might be better off purchasing the asset and reselling it yourself at the end of the three years. If leasing companies are giving high residual values, you can likely get that same value in the marketplace.

The most popular off-balance sheet lease assets are those with rapid depreciation or absolution. Any kind of electronic equipment, including telephone systems and computer equipment are good candidates for operating leases.

The most common off-balance sheet lease for petroleum marketers, however, is vehicles including tractors, trailers, tankwagons and even pick-ups. You will likely find that it is always cheaper to lease your fleet than to purchase outright. The trick with vehicle leasing is to select the economically best lease term. It’s tempting to select a short lease and have your fleet looking brand-spanking new, but it may be more economical to look at longer terms.

With vehicle leases, many providers give you the choice to include full maintenance in the lease. To know if the full maintenance lease is cost-effective, do your lease cost analysis with and without the maintenance portion of the contract. By having the leasing company quote you the lease both with and without maintenance, you will know the exact cost for the maintenance feature and can then compare that cost to your own current maintenance provider.

One final caveat — watch out for hidden extra fees. These fees can show up as origination fees, turn-in fees (when the lease is over), documentation fees, appraisal fees, etc. With vehicle leases, you must also be very accurate with your anticipated mileage. If you exceed your mileage allotment, expect to pay steeply for any overage.

Also be knowledgeable about what your leasing company considers “normal wear and tear.” There is a vast difference in non-penalized equipment condition allowances at turn in.

Finally, as with all financial transactions, be sure you company can easily afford the payments!   Too many cash-strapped companies enter into leases and then have difficulty making payments.

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