The end of "hidden debts"

Accounting is a dry subject but a very important one. I perfectly understand why private investors' eyes glaze over at the mere mention of the topic. That said, I am a firm believer that when it comes to this subject a little knowledge can go a long way and can help you make better investment decisions.

One of the most under-appreciated and important bits of accounting relates to the treatment of operating leases or rented assets. Companies in industries such as retailing, airlines, telecoms, oil and transportation have a tendency to rent rather than own a large chunk of their assets. I often refer to these as "hidden debts". They can affect the way a company's financial performance is presented to investors and can make it difficult to compare with similar companies which own similar assets outright.

From January 2019, the way companies account for operating leases is going to change and this will change people's perceptions of key performance measures such as profit margins, debt levels and return on capital employed (ROCE).

In this article I'm going to explain how leasing affects keys investment ratios, how the new accounting rules will affect financial statements, and how SharePad already helps you adjust for operating lease commitments.

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What are operating leases?

I am going to try and make this as straightforward as possible. Operating leases occur when a company rents an asset such as a building or a piece of equipment from the owner for an agreed period of time. The company does not own the asset and typically has no right to buy it at the end of the rental period.

Renting or leasing is essentially a financing decision for a company. For some companies it can be the right thing to do. Renting gives advantages such as flexibility as well as protecting the company from risks such as technical obsolescence or a falling residual value. The big financial advantage is that the company does not have to borrow large amounts of money to buy an asset outright.

Because the company does not enjoy the risks and rewards of ownership of the rented asset, the value of it is not shown on the balance sheet. Its obligation to pay rent - sometimes for many years in the future - is not shown as a liability either.

Why is the accounting treatment changing?

The International Accounting Standards Board (IASB) has decided that, for financial years beginning from January 2019, operating leases will essentially cease to exist. The value of rented assets will have to be shown as an asset on a company's balance sheet and the obligation to pay rents in the future will be shown as a financial liability similar to borrowings.

The IASB believes that investors and analysts do not have a complete picture of a company's financial position with the current treatment of operating leases. It believes that a company's financial liabilities are understated when it has significant future rent obligations.

It is also makes it difficult to compare similar companies where one rents assets and the other owns assets without making significant adjustments.

Generally speaking, I think this is a very good idea. It is too easy - particularly for inexperienced investors - to think that a company is debt free when it isn't. Retailers are a prime example of this. The inability to pay rents on high street shops is a major reason for retailers going bankrupt even if they have no borrowings.

More importantly, renting assets understates the real value of assets employed in a business and overstates the true ROCE it is making. Think about this for a moment: is it really true that two identical retail businesses with identical assets, profits and cash flows can have different returns on capital just because one chooses to rent rather than own its shops?

This is why high street retailers with rented shops appear to have no debts and high ROCE. Some do, but many do not when the adjustments proposed by the new accounting standard are applied.

Credit rating agencies and many professional analysts have been making these adjustments for some time. From 2019, no-one will have to and I think that is a good thing.

The effect on company balance sheets

There will be three main effects of the new leasing standard:

  1. Non-current assets will increase. This will be by an estimate of the present value of future lease payments.
  2. Financial liabilities will increase by the amount of future lease payments that will have to be paid.
  3. Accountants are a little unclear but think there will be an initial reduction in shareholders' equity. This will happen as the asset value will initially fall faster than the liability due to depreciation of the leased assets outweighing the interest on the lease liabilities.

The effect on income statements

This is best explained with an example. From 2019, the operating lease expense line will completely disappear from company income statements. Instead, the expense will be reallocated between depreciation and interest expenses.

XYZ plc (£m)NowAdjustmentFrom 2019
Op. lease expense(100) 0
EBITDA400100500
Depreciation(100)(70)(170)
EBIT300330
Interest(50)(30)(80)
Profit before tax2500250

From 2019, the operating lease expense line will completely disappear from company income statements. Instead, the expense will be reallocated between depreciation and interest expenses.

Let's take a look at the impact on a company with £100m of operating lease expenses:

  • EBITDA will increase by £100m. The whole operating lease expense consists of interest and depreciation so is added back to the unadjusted EBITDA. EBITDA is telling us what profits are before these two expenses are deducted.
  • Depreciation will increase by £70m. The depreciation part of the operating lease expense is added to the existing depreciation on other fixed assets.
  • EBIT increases by £30m. This is because the interest part of the operating lease expense has been reallocated to the interest line.
  • Interest expense increases by £30m.
  • Profit before tax is unchanged.
  • The effect on profits after tax and earnings per share (EPS) is uncertain. This is because it depends on how the tax authorities treat the tax deductibility of lease interest. Personally, I do not expect a big change.

The effect on cash flows

Essentially there will be no change.

  • Operating cash flow will increase as the interest charges on leases are reallocated to Financing cash flow.
  • Financing cash flow will decrease due to these interest charges.
  • No change to net cash flow.

Effect on financial ratios

RatioChangeExplanation
Leverage (Debt/Equity)IncreaseDebt up, equity down.
EBIT marginIncrease EBIT increases by lease interest.
EBITDA marginIncrease EBITDA increases by lease expense.
EPSNot clear Depends on tax treatment of lease interest.
ROCENot clear In many cases it will fall if the increase in lease interest added back to EBIT is proportionally smaller than the increase in capital employed from the value of capitalised leases.
Operating cash flowIncrease Lease interest expensed in financing cash flow.
Free cash flow for equityNo changeCash flow effects net off.

SharePad and capitalised operating leases

Up until 2019 you have a choice if you want to adjust for or ignore the effect of operating leases on how a company's financial performance is portrayed.

If you want to see the effects then SharePad has been able to do this for the last two years. We think that we are the only private investor software provider that allows you to do this. It is really easy and straightforward to do.

When you add columns or criteria for items like ROCE and EBIT margin, you will see options for using a lease-adjusted calculation.

I am a big fan of taking operating leases into account as I feel it gives me a truer and fairer view of a company's performance. It gives me more confidence that a company has a high ROCE and debt liabilities it can cope with.

We estimate the capitalised value of leases by applying the same approach as credit rating agencies. We multiply the annual operating lease expense by 7 (usual range 6-8) and multiply that value by 7% to get an estimate of lease interest. These are the default settings in SharePad; you can choose different values if you want to.

You can see a comparison of unadjusted and adjusted values for easyJet and Next, taken from SharePad, in the tables below.

easyJetNext
Rent£119m£215m
Capitalised leases (7x, 7%)£833m£1,502m
EBIT£501m£828m
Lease-adjusted EBIT£559m£933m
EBITDA£670m£944m
Lease-adjusted EBITDA£789m£1,159m
Capital employed£4,024m£1,718m
Lease-adjusted Capital employed£4,857m£3,220m
Net borrowing£42m£919m
Lease-adjusted Net borrowing£875m£2,421m
easyJetNext
EBIT margin10.7% 20.2%
Lease-adjusted EBIT margin12.0%22.8%
EBITDA margin14.3%23.0%
Lease-adjusted EBITDA margin16.9%28.3%
ROCE13.8%51.4%
Lease-adjusted ROCE12.5%30.0%
Net debt to EBITDA0.061.0
Lease-adjusted Net debt to EBITDA1.12.1

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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.