If your business needs new equipment, machinery, vehicles, or other assets, there are various forms of asset and equipment finance solutions to choose from. An operating lease is one option that allows you to rent assets (rather than buy them on finance) for a set period with minimal commitments.

In this guide to operating leases, we explore their key features, benefits, use cases and how they differ from other lease agreements, or alternative finance solutions, such as flexible business loans.

What is an operating lease?

Operating leases are a form of asset finance enabling a business to use an asset for a set period without purchasing it outright. Whereas many other asset finance solutions have options to own the asset after an initial term, sometimes via a balloon payment, operating leases are a more stripped-down agreement for using assets and equipment, including vehicles, for commercial purposes.

Let's explore the key features, benefits and differentiators between other forms of asset finance, including finance lease, contract hire and hire purchase agreements. 

Definition and key features of an operating lease

An operating lease is a rental agreement in which the finance provider (lessor), typically a financial institution or leasing company, transfers the right to use an asset to the business (lessee) for an agreed-upon period. The lessor retains ownership of the asset while the lessee pays periodic lease payments. 

Here are the key features of operating leases:

1. Short-term or medium-term leasing of assets with regular payments for use.
2. Lease payments are lower than the cost of purchasing the asset outright, as the lessee only pays for the period of use, not full ownership.
3. There’s no transfer of ownership at the end of the lease term, and assets are normally returned to the lessor.
4. Businesses have the flexibility to upgrade or replace leased assets at the end of the term, which is ideal for constantly changing equipment needs.
5. Maintenance and repairs are often handled by the lessor, while insurance and depreciation responsibilities may also sit with the lessor, depending on the agreement.

Operating lease vs finance lease: what are the key differences?

Operating lease and finance lease agreements have some key differences businesses should be aware of, mainly surrounding ownership, commitment levels and accounting treatment. While operating leases allow businesses to use assets without taking ownership, offering flexibility, lower upfront costs and easier upgrades, finance leases (or capital leases) work more like asset purchases, spread over time.

Here is how these asset leasing types differ across various factors:

• Ownership: In operating leases, ownership remains with the lessor, while businesses have options to purchase assets within finance lease agreements.
• Lease terms: Operating lease terms are typically shorter and tied to usage periods. Finance leases usually span the majority of the asset’s lifecycle.
• Costs: Operating leases usually have lower, short-term payments, whereas finance leases are more suitable for long-term financing of an owned asset.
• End-of-term options/flexibility: Finance leases often include options to purchase assets outright or continue using them after the initial period, at a lower rate. Operating leases allow businesses to return or upgrade assets after the agreed-upon usage period.
• Balance sheet treatment: Some operating leases may qualify for off-balance-sheet treatment if subject to International Financial Reporting Standards (IFRS 16) exemptions, while finance leases must always appear on the balance sheet.

Other forms of asset finance and how they differ from operating leases

Operating leases are just one form of asset finance. They’re simpler solutions than most, with fewer commitments and clear costs and conditions. So, how do they compare?

Comparing an operating lease vs contract hire and hire purchase agreements

• Operating leases, contract hire leases and hire purchase agreements all help businesses access assets and spread their costs, but differ in flexibility and ownership. An operating lease is a shorter-term option to use assets for a set term without ever owning them – ideal for assets needing regular upgrades.
• Contract hire leases are mainly used by businesses hiring vehicles. They’re a type of operating lease that often includes maintenance, servicing and other running costs, which simplifies fleet management.
• Hire purchase agreements have an option to buy the asset. Businesses pay instalments, taking on various responsibilities from the outset, with the prospect of owning assets after the initial hiring period, via a balloon payment. This solution suits longer-term asset use and eventual ownership needs.

The importance of operating leases in business

Operating leases can be valuable options for businesses as they provide access to essential assets without high upfront costs or long-term commitments. This helps you preserve working capital for other priorities, such as business expansion, inventory management, marketing efforts and staffing needs.

They are ideal for short-term asset needs and temporary requirements, or for hiring without strings, where you can also upgrade assets to newer or more advanced models at the end of each term. 

Additionally, they often provide tax advantages, as operating lease payments are typically deductible, making them a strategic tool for efficient operations.

Operating lease use cases for UK businesses 

Let’s explore how certain businesses can benefit from these leases for commercial asset use. Here are some key operating lease use cases in different sectors:  

• Retail: Whether upgrading POS systems or improving store infrastructure, retailers can use operating leases to access equipment without a large upfront expense, keeping cash available for inventory, marketing or staffing costs.
• IT solutions: Computer equipment, systems and software are constantly advancing, so tech companies need frequent upgrades to maintain performance and competitiveness. Operating leases provide easy ways to lease tech assets and refresh solutions before they become obsolete.
• Construction: New construction projects require various tools and heavy machinery before and throughout builds. Many of these are expensive and may only be needed for specific projects. This form of leasing avoids high ownership costs and maintenance responsibilities.
• Manufacturing: Firms can scale or improve production lines and get access to the latest robotics without committing to long-term ownership or high investment costs while avoiding depreciation impact as technology advances.
• Healthcare: Medical technology is also advancing quickly, so operating leases enable hospitals, clinics and other healthcare providers to keep up to date and modernise facilities without tying up crucial working capital. 

The legal framework for operating leases in the UK

The UK legal framework for operating leases revolves around accounting standards and regulatory requirements that ensure consistent reporting and clear disclosure of lease obligations. Key elements are IFRS and UK GAAP, which outline accounting principles and standards companies must follow for financial agreements like leases.

The UK Companies Act also influences how operating leases are managed, guiding businesses about their legal obligations, financial reporting rules to follow and when and how to disclose the use of lease agreements.

Additionally, HMRC dictates how operating lease payments are treated tax-wise, providing rules on how to record lease payments in accounts and comply with tax regulations.

What are the rights and obligations of parties in an operating lease?

In an operating lease, both lessor and lessee have defined rights and responsibilities. The lessor retains ownership of the asset, receives lease payments and can enforce the lease terms. The lessee has the right to use the asset for the agreed term, provided they follow the lease conditions and relevant regulations. 

At the end of the lease, the asset must be returned in good condition (allowing for normal wear and tear). While some responsibilities, such as maintenance or insurance, may be shared, operating leases often place more of this on the lessor, making them attractive to many businesses.

‍What are the financial and tax implications of operating leases?

Operating leases differ from other asset finance options in how they’re recognised and treated for tax purposes. Below is an overview of the financial and tax implications of operating ease for businesses looking to use one.

Impact on your balance sheet and cash flow

Historically, operating leases were off-balance-sheet arrangements, with payments recognised as operating expenses and recorded as operating cash outflows. Under IFRS 16, most leases must now be brought onto the balance sheet as a right-of-use asset and lease liability, influencing financial metrics, such as gearing and return on assets. 

However, if you’re an SME subject to UK GAAP (FRS 102), you may still enjoy off-balance-sheet treatment for operating leases.

What are the operating lease tax implications?

Operating leases typically offer tax advantages, with lease payments generally being tax-deductible, reducing your taxable profit level. VAT is charged on each lease payment rather than upfront on the full asset value, supporting smoother cash flow and allowing VAT-registered companies to reclaim it.

Under IFRS 16, lease costs are split into depreciation and interest, rather than a single operating expense. Exemptions for short-term and low-value leases allow some businesses to continue benefiting from the simpler, expense-only treatment.

Advantages and disadvantages of operating leases

As mentioned, there are various advantages of using operating leases, but it’s also important to understand the potential drawbacks, depending on your needs and circumstances. Below are the many pros and cons of operating lease agreements:

Benefits of choosing an operating lease

• Improved cash flow through lower lease payments, which frees up resources for core business operations.
• Flexibility to upgrade or replace assets easily, helping businesses stay competitive and up to date.
• Operating lease payments can reduce your overall taxable income.
• Off-balance-sheet treatment of leases (if outside of IFRS 16) improves financial ratios.

Potential drawbacks and risks to consider

• Higher long-term cost, as leasing can technically be more expensive long-term than purchasing the asset outright.
• Requirements to keep up with regulatory changes and compliance rules, including new accounting rules for lease treatment and costs.
• Choosing and managing leases can be complicated and time-consuming.
• You have less control over asset use in operating lease agreements, with various restrictions and no option to purchase assets at any point.   

When to consider flexible alternatives to operating leases

If your asset needs are long-term and you want to have more control, including a future purchase option, you may be better off with alternative asset finance solutions, such as hire purchase or finance lease agreements. Research your options and the suitability of different solutions in our asset finance resource hub.

You could also take the small business loan route to spread the cost of acquiring commercial assets. Unsecured loans can be a good alternative to operating leases and other forms of asset finance, offering fast access to finance, without the need to use assets as collateral, with repayments tailored to your cash flow.

With iwoca, our Flexi-Loans are designed for SMEs in the UK looking to grow their businesses while managing cash flow effectively. You can borrow between £1,000 and £1 million for days, weeks or months (up to 60 months), catering to short- to medium-term finance needs, and only pay interest on what you actually use. 

Discover how to apply for our flexible loans and their key benefits, and use our handy business loan calculator to see your likely repayments. You can apply in minutes and get an approval decision within 24 hours.