Hire purchase is a financing method used widely by many small and medium-scale businesses to purchase fixed assets for their business operations. This method is widely used and has been a good option for businesses that do not want to indulge in paying high initial costs or have budget issues to mitigate the high purchasing cost. Under the hire purchase system, the financing works in the form of installments where the buyer has to pay the purchase price in subsequent installments, and upon the completion of all the installments, the asset ownership is transferred to the buyer.
Hire purchase system has been a major boon for industries and businesses and the entire concept has been a crucial part of the accounting system for centuries. There are specific accounting standards governing the hire purchase laws that need to be followed as part of the procedure. The use of the hire purchase system presents a lot of benefits alongside a few drawbacks which we’ll discuss in detail down below. Read along.
Advantages of Hire Purchase System
1. Easy to finance
The hire purchase system is an easy-to-perform system that is ever present and common among industries and businesses. You can find both sides of the parties, the buyer and the company willing to conduct the hire purchase deal with them. A lot of companies run on this model to lessen their overheads and capital expenditure whilst giving them the benefit of having a machine or a vehicle to run their operations. The term is very common and all the business houses ranging from the small scale to the large corporations practice it regularly.
2. Ability to gain ownership at the end of the term
Compare the hire purchase system to the rental system and you’ll see why companies practice it. In the case of the rental agreement, you pay the rental charges for the machinery or the vehicle and use it for the period as per the agreement and the said machine or vehicle is returned to the owner at the end of the cycle. Whereas in the case of the hire purchase system, you pay the monthly installments and at the end of the period get the ownership of the machine. That way you can own the machine yourself in the end.
3. Less Capital Outlay
Buying a machine or a vehicle right away requires a large scale of capital expenditure. That much amount of financing can be a difficult task for small-scale and medium-scale business which needs to balance their books and run the company efficiently. But again, the lack of such a machine will hamper the production levels of the company too. This is where hire purchase systems come into play. The hire purchase system allows you to get the machine at hiring cost or in installments and run your business operations without the need for a massive capital influx. This way you don’t have to worry about the books of accounts and focus on manufacturing or building your product for sales and efficiently run your operating cycle.
4. Depreciation benefits can be claimed
Depreciation is a major business impetus that allows companies to lessen their costs and cater to the future life cycle of the machine. In the case of rentals, you cannot avail the depreciation benefit. But with a hire purchase, you can avail of depreciation benefits and maintain the depreciation cycle on your books of account. This will help in reducing the profit levels and save taxes for the business. Furthermore, when you get ownership of the business later at the end of the hire purchase contract, the machinery value will be in line with the usage cycle and will reflect the correct value proposition.
5. Capital Budgeting benefits
A business needs to cater to multiple cost analyses and budgeting propositions. There may be various areas of work that will need capital expenditure at one time and the ability to make the proper financing decisions will impact directly on the business or the growth. Use of hire purchase allows the business to focus on other areas of capital expenditure and spread that amount to other areas of concern without the fear of losing out on the required machinery as the hire purchase system will give you the machinery for use.
Disadvantages of the Hire Purchase System
1. Ownership can be transferred only at the end of the cycle
Though hire purchase allows a business to own the machine, it only occurs at the end of the cycle, i.e. after the last installment payment is done. This at times can be detrimental to the business if they are run based on an asset ownership policy. Till the time the hire purchase cycle is running, the machine or the vehicle isn’t yet owned by the business and can’t be claimed as one of their assets.
2. Not all equipment or machines can be hire purchased
The hire purchase system requires a business concern to find another such concern willing to participate in the hire purchase deal. There can be times when the required machinery or the vehicle cannot be found under the hire purchase system and this will impact the business operations if such machinery or equipment is of major need.
3. Tedious process
When as a business concern you buy machinery or equipment, you directly gain the ownership of the same and can mark it as an asset in the books of account. However, with the hire purchase system, there needs to be a contract drawn upon for the terms of the hire purchase alongside the timely installment payments to be done. This entire cycle is a hectic and tedious process and will require accountants to devote their time to maintain the upkeep and smooth running of the hire purchase system.
4. Higher cost and interest rates
Hire purchase is essentially a rental kind of deal where at the end of the cycle you get the ownership of the said machine or the equipment. As it is with other means of financing, hire purchase comes with high interest rates and at times the overall cost of the machine at the end of the hire purchase cycle can be higher than what you’d have paid if you had bought the machinery at the very beginning. This is often the case with all financing and term-based deals.
The hire purchase system is a common procedure that is followed by major companies across the world for various machinery and equipment purchases. It is a great financing option for companies looking for machinery and can help a lot. We hope the aforementioned advantages and disadvantages help you understand the concept better.