Equity Analysis: Operating Lease – The Hidden Debt by SG Value Investor, The Value Edge

Firms often choose to lease long-term assets rather than buy them for many reasons – tax benefits, smaller cash outlay etc. Lease contracts create future obligations for the firm in terms of rental payments and can therefore be viewed as a form of liability in our opinion. Unfortunately, these are easily overlooked by investors due to the way they are accounted for in the books.

There are two ways of accounting for leases – Capital Lease and Operating Lease.

Capital Lease

Otherwise known as a finance lease, there are a few conditions stipulating when a lease is to be classified as a capital/finance lease depending on which accounting standards the company follows. As a capital lease, the asset (usually a property) will be recorded in the balance sheets as an asset under PPE, offset by a liability corresponding to the present value of all future lease payments. The main consequence of this is that a firm incurs both depreciation and the interest expense component of the lease payment in its P/L statement.  By capitalising leases, it can increase the debt shown on the balance sheet significantly for firms in industries like retailing. This is why capital lease is usually not the preferred way of accounting for leases.

Operating Lease

When a lease is classified as an operating lease, the lease payments are simply deducted as rental expenses from the P/L statement. Unlike capital leases, an operating lease is not included in the balance sheet in any way. Operating leases are only disclosed in the Notes to Financial Statements and categorised as future minimum lease payments payable under 1) the next year, 2) year 2 to 5 (inclusive) and 3) beyond 5 years.

What this means to an investor

As most firms utilize operating leases in their accounting, it is important that investors be mindful of this and make the necessary adjustments to their financial ratios and analysis. The most impacted type of company would be retailers who lease the majority of their store network. Recently, we were researching into a Hong Kong listed company – Bauhaus that appeared on our screener trading at valuations of PER 8.82x, EV/EBITDA 4.51x and FCF Yield 17.3%. Furthermore, taking a quick look at their financials, Net Income grew at a 9 year CAGR 11.6%, Gross Profit and Net Profit Margins remained above 60% and 6.5% over the last 9 years, Debt to Equity Ratio of 0 etc. Initially, we were pretty excited having discovered such a Multi-National Company at such low valuations till we came across their ‘Operating Lease Arrangements’, which sparked the discussion between ourselves. Based on the assumption that operating leases are ranked pari passu with borrowings as a form of liability, the debt to equity ratio ballooned from 0 to 0.7x, which was beyond our threshold level. However, there is definitely wiggle room in this adjustment of operating leases, depending on an individual’s concept of risk and discretion. What is most important is that readers are fully aware of the implications in the way they choose to perceive operating leases.