Lease Accounting: Impact to Ratios (Schweser Book 2, page 55)

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OMGMileyCyrus

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Hi,
I am having trouble understanding why the debt-to-assets (Debt/Assets) ratio is higher under a Finance Lease versus Operating Lease.
If a firm has a debt to assets ratio of 2.0 (let’s say $10 of Debt to $5 of Assets), and the firm decides to take on a Finance Lease with a PV of $4, this will create both an Asset and Liability for the firm of $4 on the Balance Sheet. Whereas, using an Operating Lease, there would be no impact to Assets or Liabilities as Operating Leases treat payments solely as interest expense (no Balance Sheet impact). As such, our ratio is now 1.56 ($14 of Debt to $9 of Assets due to the increase in Debt by $4 for the Liability piece, and an increase in Assets by $4 for the Asset piece of the Finance Lease).
Using the Schweser Notes, Book 2 page 55 gives a breakdown of the comparison in ratios between Finance and Operating Leases. Can someone help me understand why the text has Debt/Assets as higher under Finance Lease compared to Operating Lease?
Thanks!
OMGMileyCyrus
 
Hmmm I think I found my answer (Schweser Book 2, page 56):

“Second, adding equal amounts to assets and liabilities will typically increase the debt-to-assets ratio. Since assets are typically larger than debt (liabilities), the numerator of the debt-to-assets ratio increases by a greater proportion than the denominator when equal amounts are added to each, so the ratio increases.”

So Debt/Assets is higher under Finance versus Operating Leases assuming that Assets > Debt before adjusting for the Asset and Liability piece generated by the Finance Lease.

Does this sound right?
 
Yea…. Assets = Liabilities + Equity, meaning asset value is larger than liability value since most companies have positive equity.
 
Alternatively, because Assets are higher than liabilities generally, you can just conceptually think of this relationship as pushing the debt/asset ratio towards 1:1. Because debt is usually less than assets, you’re starting with a ratio that is less than 1 and moving closer to 1.0 (increasing)
If a company has negative OE, the opposite is true because debt/assets ratio would originally be higher than 1.0, and adding an equal amount ot both sides woudl push the ratio towards 1:1
 
sglondon’s view has a lot to recommend it.
Although CFA Institute generally takes the default position that a company has positive equity, it’s still a good idea to visualize what happens when a company has negative equity. If nothing else, it helps solidify your understanding of why the ratios change as they do, which is a far cry better than merely trying to memorize a table.
 
Thanks guys! I definitely appreciate the help. Explanations concerning positive/negative OE helped greatly.
 
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