On-Balance Sheet Operating Leases - Financial Statements and Valuation
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- čas přidán 7. 08. 2024
- In this tutorial, you’ll learn how accounting rule changes in 2019 around Operating Leases impact financial statement analysis and valuation, and what to do when calculating metrics such as Enterprise Value.
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Table of Contents:
0:49 The Short Answer
4:33 Changes on the Financial Statements
8:40 Examples for Target and EasyJet
11:48 Valuation Multiples and Metrics
15:50 Recap and Summary
Under both U.S. GAAP and IFRS, companies now report Operating Leases as Liabilities on their Balance Sheets, along with “Right-of-Use” Assets corresponding to them on the Assets side.
Under U.S. GAAP, companies still record Operating Lease Rent as an Operating Expense on the Income Statement.
Under IFRS, companies now split the old Rental Expense into Depreciation + Interest components on the Income Statement.
Under IFRS, on the Cash Flow Statement, Cash Flow from Operations will increase due to the additional Depreciation, but Cash Flow from Financing will fall due to the “Repayment of the Capital Element of Operating Leases,” which offsets Depreciation.
Under U.S. GAAP, nothing about the Cash Flow Statement changes.
Despite these changes, most companies’ Net Income and Net Change in Cash figures barely change! It’s still the same total expense, just presented differently.
In valuation, you can add Operating Leases to calculate Enterprise Value, but if you do so, then you must then exclude all lease-related expenses on the Income Statement in the denominator, in metrics such as EBIT and EBITDA.
Under U.S. GAAP, effectively, you must use EBITDAR if you count Operating Leases as Debt in the TEV calculation.
If you do not count Operating Leases as Debt in TEV, then you can use traditional metrics like EBIT and EBITDA and pair them with TEV.
Under IFRS, you can’t really use EBIT anymore, and when you use EBITDA, you need to pair it with a TEV metric that includes Operating Leases. Also, EBITDA and EBITDAR are now effectively the same.
For returns-based metrics, such as Return on Invested Capital (ROIC) and Return on Capital Employed (ROCE), the treatment gets a bit tricky because companies define them slightly differently.
However, both ROIC and ROCE typically use NOPAT, or Net Operating Profit After Taxes, in the numerator, and then Invested Capital or Capital Employed in the denominator.
Invested Capital or Capital Employed are usually defined as Average Shareholders’ Equity + Average Debt - Average Cash + Average Operating Leases.
For historical periods in which the leases are not yet on the Balance Sheet, you can capitalize them manually by multiplying the rental expense by 7x or 8x.
If Invested Capital or Capital Employed are defined like that, then the Operating Income number you use to calculate NOPAT must exclude the Interest Element of Operating Leases now - even if the company follows U.S. GAAP!
So, the company will have to split out a portion of its Rental Expense and count it as an “add-back” to remove the Interest Portion of the lease expense. You can see an example of this in Target’s filings.
![US GAAP vs. IFRS in Valuation and Financial Modeling [REVISED]](http://i.ytimg.com/vi/jFplsqw3vG0/mqdefault.jpg)
Great and comprehensive video as always, covers all my questions on US GAAP vs IFRS, impact on valuation and ROCE/ROIC... thanks!
Thanks for watching!
Very timely video Brian. Thanks!
Thanks for watching!
This is great, thanks!
Thanks for watching!
Very good presentation. You are really good. Well done and many thanks.
Thanks for watching!
Really very helpful videos
Thanks for watching!
Hi Brian, really informative video. Had a question on this.
How is FCFF calculation impacted when I'm doing a DCF valuation?
Can you do a video showing how an FCFF would work when I'm converting operating leases to debt?
Please see: czcams.com/video/MRHXaUOW3cU/video.html
FCF should not change much for U.S.-based companies... for IFRS-based companies, FCF will increase because rent is now split into Interest + Depreciation components, and only Depreciation factors into Unlevered FCF.
Didn't Aswath Damodaran always recommend that operating leases be removed from the P&L and treated as debt?
Yes, he recommended that even before the rule change. We don't agree entirely with that logic because operating leases are still somewhat different than debt, but with the new rules, it is probably easier just to count them as debt in most regions.
Hey Brian, please suggest me the approach here.
1) For comparable companies analysis- I have taken the recent EV/EBITDA of comparable companies, which by default add lease liability in EV while EBITDA does not have any rent expense
2) For comparable transactions- The transactions in my list are before 2017. Hence most of the transaction multiple doesn't take the impact of new IFRS 16
The question is if I am valuing the target company in 2020 having EBITDA without rental expense. Then using the multiple from the Comparable companies analyis will be consistent, but from the comparable transactions will not be consistent to the target EBITDA. What adjustments can be made to make it consistent or is it fine to use the multiple arrived
Would like to know your thoughts?
If the transactions took place before 2017, it doesn't matter because leases were not on-balance sheet back then, and EBITDA was lower since it deducted the full lease expense. So, both the numerators and denominators were lower. Just use the multiples as they are.
Regarding modeling, what if we are given maturitires schedule in notes to financials do we than decrease lease assets and liabilities by same amounts?
No, because companies also sign new leases all the time, and they don't disclose expected new signings. It's better just to make Lease Assets and Liabilities increase gradually over time, in-line with Revenue.
Hi Brian, quick question. For FCCR calculation under the US GAAP do you have to add rent expense to EBITDA in the nominator and add the same lease expense to the denominator to account for operating lease as debt? Thank you
People define the FCCR in different ways, but the numerator should be "FCF Available for Fixed Charges" and the denominator should be "Total Fixed Charges," which usually means Interest Expense + Fixed Debt Principal Repayments + Lease Payments.
The numerator should be something like EBITDAR - CapEx - Cash Taxes - anything else the company is required to pay before the fixed charges, so yes, you should add back rent because rent itself is a fixed charge.
Could you please share that how we would show it by journal entries to show operating lease in balance sheet ?
Take a look at one of the Big 4 accounting guides on this topic. We don't cover journal entries, as they're more in the realm of pure accounting vs. valuation/financial modeling.
If you are running a DCF for a U.S. based (GAAP) company that has capitalized operating leases on the B/S, you wouldn't add the operating leases in your build from TEV to equity value because the expenses associated with capitalized operating leases are captured in unlevered cash flows, right? (They're embedded in SG&A / COGS, so even EBITDA includes them no?)
Correct. Operating Leases only factor into the bridge if you exclude or "add back" the Rental Expense in metrics like EBIT and EBITDA.
Brian! Quick questions! Facebook's 2021 yr end financials show operating leases right of use and operating lease liability on the BS. The lease payment flows as an expense. How would you adjust EV/EBITDA,, EV/EBIT and P/E?
IF I were to calculate the PV of the future lease payments and estimate the depreciation expense. add the debt back that I calculated to EV and subtract 2021 lease pmts and add the portion of depreciation to EBIT, would I be correct?
For P/E, would I need to add the interest portion of the lease after-tax?
Can I just use the lease liability on the BS to add as debt instead of calculating it?
Thank you so much!
We cover this topic elsewhere. You shouldn't adjust multiples for U.S. GAAP-based companies because the operating lease expense is a simple OpEx on the Income Statement and is not split into Depreciation and Interest. So it's simplest to count it that way and not count the lease liability in the TEV calculation at all.
@@financialmodeling Thank you. But for valuation purposes. Companies like Facebook don't consider the lease as LT-debt on the balance sheet. Should we reclass the lease liability as debt from a valuation stand point?
@@javierloa9197 No. Again, why would you? It just creates extra work and adds nothing to the analysis or conclusions.
BUt how do you forecast it moving forward
For U.S. companies, lease assets/liabilities can be a simple % of OpEx or SG&A (or a $ per sq. ft. figure). Under IFRS, link the Lease Interest/Depreciation/Principal Repayments to the company's square meters, locations, factories, or some other space-based physical metric. If you can't find them, you can also link the metrics to revenue or operating expenses or the employee count.
Hi Brian, good?
Is possible to have access to this spreadsheet?
Best
Click "more" and scroll to the bottom.
Why are operating lease assets and operating lease liabilities not the same?
Assets refer to the physical items that the leases correspond to (factories, buildings, equipment, etc.). The lease liabilities themselves refer to the future monthly/annual payments that are owed to rent those items.