Operating Lease Adjustments

[VirtualM]

In Schweser, they give three ratios that are affected when adjusting an operating lease into a finance lease:
- Financial Leverage (Assets/Equity)
- Total Debt-Equity (Debt/Equity)
- Interest Coverage (EBIT/Interest Expense)
For the first two, assets and debt are increased when adjusting, but not equity. For the third, both EBIT and interest expense are adjusted to reflect the depreciation and interest expense of the finance lease.
My assumption is that the first two ratios refer to a time period one year earlier than the interest coverage ratio. This is because the interest coverage ratio refers to changes that will impact Net Income, and eventually Equity. However, the first two ratios do not consider any changes to equity.
Is my assumption correct, or is there another explanation for why Equity does not change for the Financial Leverage and Debt/Equity ratios?

 

[Ernest Seow]

If you adjust from an operating lease to finance lease,
During early years:
Rent expenses (operating lease) will be lower than depreciation + interest expenses (for finance lease) and this result in a higer Net Income for Operating lease. By converting from operating to finance lease, net income figure will decease during the early years of the lease. Since Net income is a component of equity, equity will decrease. Coupled with an increase in asset (as now lease is being recorded as both an asset and liability in the balance sheet), this result in a net increase in Financial Leverage Ratio. The same applies for Total D/E ratio.
During later years:
Rent expenses will be higher compared to the depreciation + interest expenses for finance lease. Net Income (under Finance lease) will be higher, and hence Equity will increase for finance lease. This cause both financial leverage and D/E ratio to decrease.