financing vs. operating lease: impact on debt / asset ratio

[cnd]

Schweser Assigned Reading # 18 p 55 says that Debt / Asset ratios will be higher in a finance lease than in an operating lease. Why is this? Debt will be higher because the lease liability will be included in debt, but Assets will be higher as well, because Book Value of the asset will be added there also, right? So how can one say that Debt / Asset ratios will be higher?

 

[Babbabooey]

because the percentage increase in debt will be higher than the percentage increase in assets

 

[Wojtek]

To illustrate the point rightly made by Babbabooey:
Imagine a company with Assets = 100, Equity = 60 and Liabilities (debt) = 40. If the company were to lease an additional asset worth 10 under an operating lease agreement, neither the asset itself nor a liability would be recognised and the debt to assets ratio would stand at:
Debt/Assets = 40/100 = 0.4
If the same asset (worth 10) were leased under a finance lease agreement, the balance sheet effect would be to increase assets and liabilities by 10 resulting in: Assets = 110, Equity = 60 (no change) and Debt = 50. The adjusted debt to assets ratio would be:
Debt/Assets = 50/110 = 0.45,
… so it has gone up. In fact, the only time that it would not, would be the case of asset being 100% debt financed, i.e. no equity.
If you are not sure of the ratio impact of any transaction or event in the exam, I strongly recommend that you attempt to run a mini simulation like the one above. It will always work, whatever the numbers chosen.