Introduction: Leasing: Operating leases - off balance sheet finance example
By way of a simple example, a lessor might acquire an asset for £50m and expect it to have a value of between £20m and £25m at the end of the lease term, with only a 5% chance the value will be less than £20m. So the rentals may be calculated much as they are for a finance lease except that, rather than assuming little or no value at the end of the lease term, the asset is assumed to have a value of £20m. In this simple example the lease is broadly equivalent to a loan of £30m but there is a 95% chance the lessor will make a profit in excess of his interest turn. And if the lessor has a portfolio of operating leases the risk of overall loss is very small.
You should note that although the lease is broadly equivalent to a loan of £30m the lessee will not benefit from any increase in value of the asset at the end of the lease term. If the asset has a value in excess of £30m the lessee will have ‘lost out’; if the asset has a value of less than £30m the lessee will have ‘won’ when compared to borrowing.
This is very simple example to illustrate the point. Commercial pressures will force the lessor into competitive terms, and the taking of residual value risks (i.e. the risk that the value will be less than £20m in the example above) involves a high degree of skill and judgment because it may not be possible to limit the risk of loss as much as in this simple example. The risk of loss is real, which is a strong indication that the lease is an operating lease, but that does not mean the lease is not broadly commercially equivalent to a loan. If it were not, the term ‘off-balance sheet finance’ would be inappropriate and yet it is frequently encountered in connection with lease finance.
Note that the schedules to operating leases of this type may set out the cost and implied residual value, much in the same way as happens with big ticket finance leases. (A ‘big ticket’ lease is a lease where the leased assets have a high value, generally accepted as £20m or more.) That is, the arrangements between the parties are transparent, reflecting the underlying nature of the arrangement as a loan.
A lack of transparency does not mean that the lease is not performing a financing function. Sophisticated lessees can carry out the calculations for themselves providing only that they know or can estimate both the cost and the residual value of the asset at the end of the lease term.