- Capacity is the ability of the lessee to honour his financial obligations to the lessor and other creditors as determined by the assessed viability of the business or intended use of the lease facility. This can be done by appraising the profits which are the main source of funds for servicing the lease rentals payments. Profits should be growing at an increasing rate or at least remain stable over time.
The fixed charge coverage ratio is expressed as:
Earnings Before Interest and Taxes
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Fixed Charges
and serves as a good indicator of the lessee’s capacity to pay its fixed charges from operating income. To ensure that risk is not unduly high, this ratio should be around four times and increasing over time.
- Credit refers to the credit policies of the lessee in terms of credit offered its customers and those received from suppliers and the lessee’s payment record in this regard. The lessor needs to evaluate the average collection period of the lessee, to ascertain how fast it collects its receivables as well as the average payment period to determine how frequently it honours its own obligations. The average payment period is a key measure here and it is expressed as:
Accounts Payable x 360
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Annual Purchases
The lower the average payment period and the bigger the lessee, the lower will be the risk of default on lease rental payment.
- Cash flow analysis will show the extent to which lease rental payments can be made by the lessee without necessarily jeopardising its liquidity position.
- Chronological Age of the lessee company to a large degree determines the level of risk inherent in the company. Older and well established companies with long track record of doing successful business, tend to present lower risk than newer companies and start-ups. In the latter case, the lessor should investigate the credit record and background of the promoters and major shareholders.
- Capability refers to the degree of management skills, ability and experience possessed by the lessee’s management, which can make the difference between success and failure.
- Competence and productivity in the use of the resources at the disposal of the lessee is yet another key risk factor related to capability. This can be measured by capacity utilisation of assets and the productivity ratio given as:
Earnings Before Interest and Taxes
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Total Assets
- Control is the existence of an information feedback system in the lessee’s company for facilitating the decision-making process. Control mechanism includes budgets, variance analysis systems, standard costing systems and forecasts, with which actual performance is compared to determine if the company sticks to its plans and programmes of performance.
- Course refers to the financial direction from which the lessee is coming and where it is heading. Trend analysis of financial ratios, cash flows and sources and application of funds, give clear indication of this direction. When compared to the lessee’s future plans and strategic programmes of action, the lessor begins to appreciate the viability of the lessee’s future course of action.
- Constraints and conditions in the prevailing economic and political environment in which the lessee operates which are likely to impact on the company’s ability to honour its lease rental obligations, constitute a major risk factor that must be considered by the lessor. Hence, the lessor should check the characteristics of the lessee that may increase or decrease its ability to perform on a lease contract.
- Collateral refers to the ability to pledge assets as security for the lease. Since the lessor relies on the leased equipment as security in the case of default on rentals by the lessee, it is important to understand the erosion effect of time on the value of the asset. While some assets do effectively maintain their value after a primary lease term, e.g. aircraft, others are rapidly depreciated like computers. The lease must thus be structured in such as way as to reduce this type of risk through requiring a guarantee residual value. In addition, the lessor may need to include in the agreement a preventive maintenance clause, which requires the lessee to ensure that the asset is always in good working order and its end-of-lease salvage value kept intact.
Depending on your particular need, we can arrange a special session for your staff to comprehensively discuss on the risks in leasing business. Contact us today, 08023176691, 08023179048, info@elannigeria.org, elan_nigeria@yahoo.com