UNDERSTAND YOUR RISKS BETTER (PART 1)

In leasing, lessors (owner of an asset) are faced with two major types of risks: credit and asset risks. Before you as lessors commit into any lease transaction, it is imperative to conduct a proper analysis of the lessee (user of an asset) on these two types of risk. Lessor. having assessed the credit worthiness of the lessee, it is equally imperative to assess the other risks, which may confront the lessor. These include:

(1)       OWNERSHIP RISK

The lessor as the legal owner of the asset is exposed to variety of risks. The following are some of the risks encountered by the lessors in this regard:

1, Defective Title – It is crucial for the lessor to ascertain that he has effective title to the asset. He should therefore conduct appropriate investigation to ensure that the supplier or any previous owner has good title to the asset sold

2. Loss of Leased Asset – The leased asset may be lost, destroyed or stolen. Lessor can protect himself against this risk by taking appropriate insurance policy at the expense of the lessee.

3. Third Party Claim – As owner of the equipment, the lessor may be exposed to liability from a third party arising from injury or damage caused by the operation of the equipment. It is usual for the lessor to protect himself from such claims through specific documentation including indemnification by the lessee.

4. Implied warranty of fitness – The lessor as the owner of the equipment, is expected to take reasonable care to ensure that the leased asset is in reasonably fit condition for the purpose for which it was leased. The lessor can exclude himself totally from all implied terms concerning quality or fitness of the equipment by stating in the lease agreement that the asset was selected by the lessee and does not rely on the representation or judgment of the lessor.

5. Environmental Risk – The regulatory authority may require the lessor as owner to make good any damage caused by the operation of leased asset to the environment. Lessors in exploration, extractive, and manufacturing sectors, are more exposed to this risk. Therefore, for every proposed lease facility, it is essential for the lessor to consider the nature of the equipment and the potential damage to its reputation.

2. RESIDUAL RISK

Residual value analysis is a comprehensive process aimed at determining the future value of equipment at specified times during the lease term and at expiration. The issue of residual value is very crucial in leasing. In operating lease for example, the lessor is more likely to rely upon the future value of the leased asset for its profit as the lessee’s ability to pay the lease rental. However, care must be taken in assessing the residual value. For instance, an over estimated value will cause the lessor to lose an element of its initial capital expenditure. Generally, the following factors must be put into consideration in residual valuation.

  • Inflation – the rate of inflation must be considered because this would affect replacement cost of assets in future.
  • Technological obsolescence
  • Useful life of asset
  • Rate of usage of asset
  • Rental payment
  • Secondary market

All these factors must be assessed and sensitised properly in fixing residuals. In advanced economy such as in the United States of America, residual valuation is usually carried out by specialised companies. Just like credit rating organisations, these companies engage in collection of relevant information on different equipment. Such information is processed and valid conclusion and advice is provided on valuation of residual for leasing companies.

In the absence of such service, the lessor has to take all necessary steps in using appropriate residual value in arriving at the primary rental for a transaction.

Valuation of residuals requires the lessor to take a complete view. Residual value of equipment does not readily come to play in finance lease, as the lessor is expected to recoup all its investment on the asset during the tenure of the lease. On the other hand, in a true operating lease, the lessor is not expecting to recoup the total cost of the equipment from the primary lease period. This factor makes valuation of residual under operating lease a prime factor.

Valuation techniques being adopted by lessors in Nigerian context, varies from one lessor to another. In most cases, the use of rule of thumb still prevails. In developed countries, experience has shown that valuation of residuals has to be critically assessed and sensitised because of various eventualities, which can result in residual risk.

In doing this, considerable amount of time is spent with used equipment experts and product people, who can help to figure out the worth of the equipment at the end of lease terms. Residual calculation is an art not a science. Therefore, it is not probable that a single formula for calculating residual could be formulated. This points out the fact that lessor would have to depend on their experience on each particular product and the economic situation both now and in the future in fixing residuals.

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Simple as it may sound, realisation of residuals on leased asset may prove difficult in real life. This is especially for high-specialised equipment. The best way for quick realisation of residual where there is no established secondary market, is to refurbish or upgrade the equipment. Residual risk can be mitigated by utilising the following strategies:

  • Purchase a residual value insurance
  • Link up with a manufacturer with sales personnel and a previously established second hand market to facilitate reselling of returned equipment. This is very possible in assets like computers, office equipment such as photocopiers, aircraft and ships.
  • Conservative under booking of residual values serves as a hedge against accounting losses on residuals.
  • Enter into an agreement with a manufacturer to buy and refurbish or upgrade equipment.

In aiming at an asset’s future value at specified times, the lessor must obtain detailed information on the asset to be leased. There are several sources of information that may be utilised in assessing the impact of variables on residual value and estimating an asset’s future value. These include:

  • The proposed lessee
  • New equipment vendor
  • Used equipment dealers, brokers and re-marketers
  • Specialised equipment assessors
  • Trade publications and advertisements

For some assets such as cars, information is relatively easy to obtain. However, for other more specialised assets such as a unique high value production line, predicted future value information may not be readily available and the lessor is forced to make little more than an educated guess. On such assets, it is sometimes possible to agree to share any subsequent realised loss with the lessee. In other instances, a zero booked residual is assumed.

To fully gain foothold on how best to mitigate risks in leasing, contact the experts, 08023176691, 08023179048, info@elannigeria.org, elan_nigeria@yahoo.com