debt to equity ratio under capital lease

[ecodanielv]

“operating leases not recogbized as liabilities and therefore the debt to equity ratio will be lower than a similar finance lease” Schwesser practic examen I pag 191
But I think equity is also affected. equity will be lower than a similar finance lease.
someone can explain ???

 

[S2000magician]

For an operating lease:

• you do not include an asset nor a liability for the lease, so assets will be lower than for a capital (finance) lease and liabilities will be lower than for a capital lease
• your only expense is rent – you don’t have depreciation – so your net income is higher, which means that your retained earnings are higher, which means that your equity is higher

For a capital (finance) lease:

• you include an asset and a liability on your balance sheet, so your assets are higher than for an operating lease and your liabilities are higher than for an operating lease
• your lease payment is part interest and part principle, so your interest expense is lower than your total lease payment, but you have depreciation expense which is generally higher than the principle portion of the lease payment; thus, your expenses are higher, your net income is lower, your retained earnings are lower, which means that your equity is higher lower

So, yes: equity is affected: it will be higher for an operating lease than for a capital lease, not lower.

 

[EngineIBer]

Thanks Magician sir!
Can you please explain the impact on CFO and CFF for both operating and finance lease?
Thanks once again

 

[S2000magician]

EngineIBer wrote:Thanks Magician sir!

My pleasure.

EngineIBer wrote:Can you please explain the impact on CFO and CFF for both operating and finance lease?

Sure.
For operating leases, the entire lease payment is rent: CFO.
For financing leases, part of the lease payment is interest (CFO) and part is principle (CFF).
So:

• Operating leases: lower CFO, higher CFF
• Finance leases: higher CFO, lower CFF

EngineIBer wrote:Thanks once again

You’re welcome.

 

[Banker99]

S2000magician wrote:
For an operating lease:

• you do not include an asset nor a liability for the lease, so assets will be lower than for a capital (finance) lease and liabilities will be lower than for a capital lease
• your only expense is rent – you don’t have depreciation – so your net income is higher, which means that your retained earnings are higher, which means that your equity is higher

For a capital (finance) lease:

• you include an asset and a liability on your balance sheet, so your assets are higher than for an operating lease and your liabilities are higher than for an operating lease
• your lease payment is part interest and part principle, so your interest expense is lower than your total lease payment, but you have depreciation expense which is generally higher than the principle portion of the lease payment; thus, your expenses are higher, your net income is lower, your retained earnings are lower, which means that your equity is higher

So, yes: equity is affected: it will be higher for an operating lease than for a capital lease, not lower.

On your last bulletpoint, I think it’s a typo. Equity is lower, not higher.

 

[S2000magician]

Banker99 wrote:

S2000magician wrote:For an operating lease:

• you do not include an asset nor a liability for the lease, so assets will be lower than for a capital (finance) lease and liabilities will be lower than for a capital lease
• your only expense is rent – you don’t have depreciation – so your net income is higher, which means that your retained earnings are higher, which means that your equity is higher

For a capital (finance) lease:

• you include an asset and a liability on your balance sheet, so your assets are higher than for an operating lease and your liabilities are higher than for an operating lease
• your lease payment is part interest and part principle, so your interest expense is lower than your total lease payment, but you have depreciation expense which is generally higher than the principle portion of the lease payment; thus, your expenses are higher, your net income is lower, your retained earnings are lower, which means that your equity is higher

So, yes: equity is affected: it will be higher for an operating lease than for a capital lease, not lower.

On your last bulletpoint, I think it’s a typo. Equity is lower, not higher.

Yes, that was a typo. Thanks for pointing it out. I fixed it.

 

[BaseballRedhawks]

Working capital is a question, i see them asking about. Which one will be higher…………. Since Working capital is Current Assets - Current Liability……….. Current assets does not include any of the assets of the finance lease, but the current liabilities do include the current lease payment for the finance lease.
So working capital will be lower for a finance lease.

 

[S2000magician]

BaseballRedhawks wrote:Working capital is a question, i see them asking about. Which one will be higher…………. Since Working capital is Current Assets - Current Liability……….. Current assets does not include any of the assets of the finance lease, but the current liabilities do include the current lease payment for the finance lease.
So working capital will be lower for a finance lease.

Bingo!

 

[India_28]

this would be a case in the starting years of the lease, right? Otherwise the net expense is same under both the methods, am I correct? Please correct me if I am missing something.

 

[S2000magician]

The total expense will be the same if the total depreciation in the finance lease is the same as the total principle payments, so that salvage value is the same as the residual lease value. I don’t know how common that is; I don’t believe that there’s any reason that it is necessarily so. (Accountants: feel free to correct me here if I’m wrong.)

 

[India_28]

Okay, thank you. So if on the exam they dont provide with any info. regarding this, i should follow what you told above, right?

 

[S2000magician]

India_28 wrote:Okay, thank you. So if on the exam they dont provide with any info. regarding this, i should follow what you told above, right?

That’s what I’d do.

 

[India_28]

okay, thanks a lot.