Leasing equipment instead of buying it is a factor that affects depreciation charges, inventory costs, and firm value overall. Thus, it can significantly affect the analysis ratios used to compare two different firms or the same company at a different time. Usually, start-up companies and businesses with strictly limited budgets would consider leasing equipment instead of buying it; however, other factors may also influence this decision.
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Reasons for Leasing
Sometimes firms do not have the necessary resources to buy all the equipment or materials to run their business, so they rent what they need to start operating. Also, in some cases, small businesses need to preserve cash, and leasing is a flexible option to make that happen (Cotei & Farhat, 2017). Large and well-established firms are usually less likely to rent equipment and materials, although the net profits may not show any correlation between the firms buying all they need and opting for a lease.
What Ratios May Be Affected
Any financial ratio that includes assets will be affected by a firm’s decision to lease equipment. Buying it would make a company go through a one-time sunk cost, and renting it would require multiple transactions that do not end quickly. So, in the short run, any firm that spends a large sum to obtain something needed for production may look worse off financially than the one with a lease agreement. In the long run, the situation may change radically, as the first company will no longer spend money on this asset, while the second one may end up paying multiple times the cost of it. On top of that, amortization and inflation also play their part, making such measurements as the total and fixed assets turnover ratios somewhat inaccurate when comparing two such firms (Brigham & Ehrhardt, 2020). Depending on the chosen time, one of them may appear to possess more or fewer assets than in reality.
Liquidity ratios will also be affected, as when leasing whatever they need, the firm will have more cash starting the first months but no opportunity to turn the equipment into cash. On the other hand, buying assets in many cases leave a possibility to sell them for cash when needed. Both the current and quick ratios include inventory, which is a part of assets at that time (Brigham & Ehrhardt, 2020). Comparing the firms, one of which leases the equipment and another one that does not, maybe misleading when looking at the liquidity.
Response to a Post by Tiarra MM
In the post, the author summarizes the concepts of profitability, asset management, and market value ratios. Since the profitability ratio shows the difference between revenue and cost of goods sold, it can be used as a fundamental way to measure the firm’s state. However, it is not a detailed analysis to understand if the company is using its full potential. Asset management shows how efficiently the business uses its assets, but its accuracy depends on what precisely the company possesses and how it is documented. The author also mentions the importance of using the ratio in comparing it to firms within the same industry for better results. I agree that since different business spheres use their specific logistics and operations, comparing them through financial ratios may be misleading.
Response to a Post by Amber
The author talks about the three methods of analysis: ratio, horizontal, and vertical. One of the post’s points is the necessity of considering quantitative factors, such as the environment, political threats, and economic risks. In my opinion, financial analysts would be correct to treat the state of each as a complex issue, affected by multiple internal and external factors. The numbers and ratios may provide statistics and a general idea about the business but should not be used as the only source to make conclusions.
Brigham, E. & Ehrhard, M. (2020). Financial management: theory & practice (16th ed.). Cengage.
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Cotei, C. & Farhat, J. (2017). The leasing decisions of startup firms. Review of Pacific Basin Financial Markets and Policies, 20(4), 1-30. Web.