Operating Versus Capital Lease
It is important to be aware of operating lease agreements because economically they are long-term liabilities. Whereas capital leases create liabilities on the balance sheet, operating leases are a type of “off-balance sheet financing.” Many companies tweak their lease terms precisely to make these terms meet the definition of an operating lease so that leases can be kept off the balance sheet (improving certain ratios like long term debt-to-total capital).
The present value of the combined lease commitments is almost $1 billion. If these operating leases are recognized as obligations and therefore manually put back onto the balance sheet, both an asset and a liability of $1 billion would be created, and the effective long term debt-to-total capital ratio would go from 2% to about 50% ($1 billion in “capitalized” leases divided by $2 billion).
Summary
It has become more difficult to analyze long-term liabilities because innovative financing instruments are blurring the line between debt and equity. Some companies employ such complicated capital structures that investors must simply add “lack of transparency” to the list of its risk factors. Here is a summary of what to keep in mind:
- Debt is not bad. Some companies with no debt are actually running a sub-optimal capital structure.
- If a company raises a significant issue of new debt, the company should specifically explain the purpose. Be skeptical of boilerplate explanations–if the bond issuance is going to cover operating cash shortfalls, you have a red flag.
- If debt is a large portion of the capital structure, take the time to look at conversion features and bond covenants.
- Try to get a rough gauge of the company’s exposure to interest rate changes.
- Consider treating operating leases as balance sheet liabilities.
Taken From : Advanced Financial Statements Analysis