Many years ago, the great John Paul Getty, who at one time held the title of being the richest man in the world, made the statement: “Lease what depreciates – Buy what appreciates” as a basic philosophy that must be follow prudent companies. Most of us in the leasing industry keep the statement in our arsenal as a method to convince companies to lease their equipment.
But what does it really mean? Let’s break the statement down into its two components and discuss why it makes a lot of sense.
First of all, “Buy what you appreciate” Simply put, it means owning assets that increase in value. Prudent entrepreneurs generally live by the increase rule that relates to continued growth. Revenue growth, company size growth, and net worth growth.
Very few assets that produce income and contribute to the growth of a business appreciate in value. For example, a piece of production equipment that costs $100,000 today may be worth only $60,000 or $70,000 a year from now. The team can, in fact, reduce costs by 20% and increase efficiency by 30%; however, if purchased outright, it will actually reduce the company’s net worth over time.
Assets are depreciated at a pre-established rate ranging from 10% to 50%, depending on the class in which they are found. In year 1, the amount of depreciation falls under the 50% rule, which means that only half of the depreciation can be used as an expense. The net effect is very slow depreciation for tax purposes and an erosion of the company’s net worth over time.
In second place, “Rent what depreciates”, refers to transferring ownership of any asset whose value decreases over time to a third party, also known as a leasing company. From an accounting standpoint, leased equipment is considered a form of off-balance sheet financing, meaning it does not appear as a liability on the balance sheet. This accelerates the tax effect of a lease, as if the lease is structured correctly, the payments are considered an expense and are 100% amortized from day 1. Off-balance sheet financing has the effect of improving financial ratios, as debt to equity, since debt is not included on the balance sheet.
The business model of most leasing companies is based on adding multiple assets to the financial statements, thus focusing on the huge depreciation expenses. Leasing companies thrive by adding assets to their books, in turn filling a great need for organizations acquiring assets.
One final note. Many companies have a strong propensity to own equipment, a kind of pride in ownership. It should be noted that if the purchase of equipment is secured by a bank loan or a line of credit, they do not really own the equipment until the final payment is made. In fact, they have title to the equipment and show the depreciated value as an asset, but the equipment is not owned until the loan is paid in full.
Will companies acquire equipment through a loan? Absolutely. Will companies use leasing as a means of acquiring equipment? Absolutely. The purpose of this article is to take a closer look at the statement made by Mr. Getty many years ago, “Lease What Depreciates – Buy What Appreciates”, and look at ways to acquire equipment from a different perspective. .