{"id":355,"date":"2022-03-05T14:42:24","date_gmt":"2022-03-05T13:42:24","guid":{"rendered":"https:\/\/creditanalyst.eu\/?p=355"},"modified":"2022-03-05T14:42:26","modified_gmt":"2022-03-05T13:42:26","slug":"credit-guide-02-22-financial-debt-adjustment-for-operating-leases-what-why-and-how","status":"publish","type":"post","link":"https:\/\/kurtovicfinancial.com\/en\/credit-guide-02-22-financial-debt-adjustment-for-operating-leases-what-why-and-how\/","title":{"rendered":"Credit Guide 02\/22: Financial debt adjustment for operating leases \u2013 what, why, and how?"},"content":{"rendered":"\n

What is the financial debt adjustment for operating leases?<\/strong><\/p>\n\n\n\n

The financial debt adjustment for operating leases is an analytical approach to achieving meaningful debt service capacity ratios, which serve as indicators of a company\u2019s financial health. It is only one among the many adjustments credit analysts make in their credit analyses, yet often the most important and significant one.<\/p>\n\n\n\n

Operating leases are specific to other types of debt because the accounting treatment has not yet been aligned across all accounting standards. For example, the recently adopted International Financial Reporting Standard (IFRS) 16 requires companies reporting under IFRS to recognize all operating leases on its balance sheet, with the corresponding amount of right-of-use assets. On the earnings side, companies have to recognize lease expenses under depreciation and interest expenses lines of the income statement. On the other hand, many local GAAP, including Croatian Financial Reporting Standards (CFRS), do not require companies to recognize operating leases on their balance sheet, but rather to keep them off balance sheet. Operating lease expenses are normally recorded as operating expenses, i.e., within EBITDA.<\/p>\n\n\n\n

That said, such different treatments distort several ratios relevant for credit analyses.<\/p>\n\n\n\n

Why do we adjust financial debt for operating leases?<\/strong><\/p>\n\n\n\n

There are two major reasons for adjusting financial debt for operating leases.<\/p>\n\n\n\n

The first reason is to achieve comparability of financial statements and ratios across all companies and industries. In that way, we can compare performance of companies in terms of margins, debt service capacity, returns on investment, capital structure, etc.<\/p>\n\n\n\n

The second reason is to improve analytical insight for assessing the level of credit risk. In essence, operating leases have debt-like financing characteristics, as they represent commitments for future cash outflows, which, if not paid on time, would result in a company\u2019s default. Additionally, operating leases are  often not cancellable without significant costs.<\/p>\n\n\n\n

Hence, our view is that operating leases should be included in the debt calculation.<\/p>\n\n\n\n

What are the implications of a failure to adjust the financial debt for operating leases?<\/strong><\/p>\n\n\n\n

Let\u2019s examine the implications of different accounting treatments of operating leases on the Net debt \/ EBITDA ratio of the three optical retailers we looked at recently. All three analysed companies report under the CFRS.<\/p>\n\n\n\n

Please note that Net debt \/ EBITDA should not be looked in isolation from other financial ratios. We use it here as an example because it is widely accepted by the market as one of the key ratios to assess a company\u2019s debt service capacity. We always recommend using more ratios, ideally ratios that focus on cash flows.<\/em><\/p>\n\n\n\n

\"\"
Reported vs adjusted financial debt of three leading optical retailers in Croatia<\/em><\/figcaption><\/figure>\n\n\n\n

The chart above shows serious deviations of the reported figures (i.e., unadjusted) from the adjusted figures. The differences in the Net Debt \/ EBITDA figures of the Optical retailer 1 range between 2,0x and 2,7x, which would impact ratings by one rating category in most cases under our rating methodology (for example from BBB to BB, or BB to B).<\/p>\n\n\n\n

In case of the Optical retailer 2, the variances between the reported and adjusted figures are lower and range between 1,4x and 2,1x, which would also have a rating impact. Another issue in this example is that reported figures would make us believe that the company has a net cash position, which is clearly not the case.<\/p>\n\n\n\n

The Optical retailer 3 case has highest implications on the risk assessment. While reported figures indicate a very low leverage level, the adjusted figures show that the company is actually highly leveraged! The variances amount to approx. 5,0x, which would have a detrimental impact on the company\u2019s rating.<\/p>\n\n\n\n

We believe the figures speak for themselves.<\/p>\n\n\n\n

Please note that optical retailers 1 and 3 include additional debt adjustments, which are however not as impactful as the adjustment for operating leases.<\/em><\/p>\n\n\n\n

How to adjust the financial debt for operating leases?<\/strong><\/p>\n\n\n\n

The adjustment for operating leases is normally performed on balance sheet items such as debt and fixed assets, income statement items such as EBITDA and EBIT, and cash flow items such as FFO, NOCF, and FCF.<\/p>\n\n\n\n

Balance sheet<\/p>\n\n\n\n

Debt: We use one of the Moody\u2019s rating agency approaches for debt adjustment, where we multiply the annual rent expense with a sector multiple. Alternatively, we may add to debt the present value of future lease payments, calculated using a company\u2019s average interest rate on debt as a discount rate (provided that the information is available).<\/p>\n\n\n\n

Fixed assets: We add the amount of operating leases we reclassify as debt to fixed assets.<\/p>\n\n\n\n

Income statement<\/p>\n\n\n\n

EBITDA: The lease-related expense is allocated to interest and depreciation, whereby interest expense share in total rent expense is calculated using a company\u2019s average interest rate on debt. EBITDA is increased by adding back the interest and depreciation.<\/p>\n\n\n\n

EBIT: EBIT is increased by adding back only the interest.<\/p>\n\n\n\n

Cash flow<\/p>\n\n\n\n

FFO and NOCF: both FFO and NOCF are increased by adding back the depreciation.<\/p>\n\n\n\n

FCF: for the purpose of calculating the FCF in the cash flow statement, we treat rent expense as equivalent to CAPEX, however for the calculation of debt repayment ratios which use FCF, we add back the depreciation part of the rent expense to the FCF amount.<\/p>\n\n\n\n

What is the most common obstacle to proper adjustment and how to overcome this issue?<\/strong><\/p>\n\n\n\n

The biggest obstacle to a proper debt adjustment is the absence of relevant information. For example, if a company reports under CFRS or under any other accounting standards which do not require recognition of operating leases on balance sheet, and if the company does not publish the annual rent expense figure, the adjustment is almost impossible to perform reliably. In such cases, we might estimate the level of adjustment based on industry standards and information from its peers with a similar business model. While the adjustment may prove incorrect from the amounts point of view, we believe that even such adjustment is better than no adjustment.<\/p>\n\n\n\n

If you wish to know more about adjustments of financial statements and how to apply it in credit analyses, or how debt adjustments would impact your company\u2019s credit rating, please get in touch by e-mail to mario@creditanalyst.eu<\/a>, the contact form on https:\/\/creditanalyst.eu\/en\/contact\/<\/a>, or call us on +385 98 920 17 13.<\/p>\n","protected":false},"excerpt":{"rendered":"

What is the financial debt adjustment for operating leases? The financial debt adjustment for operating leases is an analytical approach to achieving meaningful debt service capacity [\u2026]<\/span><\/p>\n","protected":false},"author":4,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[19],"tags":[32,40,41,42],"class_list":["post-355","post","type-post","status-publish","format-standard","hentry","category-credit-guide-2","tag-financial-statements","tag-financial-statements-adjustment","tag-net-debt-ebitda-2","tag-operating-leases"],"_links":{"self":[{"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/posts\/355","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/users\/4"}],"replies":[{"embeddable":true,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/comments?post=355"}],"version-history":[{"count":2,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/posts\/355\/revisions"}],"predecessor-version":[{"id":359,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/posts\/355\/revisions\/359"}],"wp:attachment":[{"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/media?parent=355"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/categories?post=355"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/tags?post=355"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}