operating leases and the Interest coverage ratio

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CFALondon0109

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when an analyst adjusts for a company that uses operating leases, will this affect the interest coverage ratio??
 
I ask because on the CFAI exam I answered teh following
An analyst made the appropriate adjustments to the financial statements of retail companies that are lessess using a substantial number of operating lesases. Compared to ratioss computed from the unadjusted atatements, the ratios computed from the adjusted statements would most likely be higher for
a. debt-equity but no interest coverage
b. interest coverage but not debt-equity
c. both debt to equity and interest coverage
d. neither
I answered C and it responded with
Correct answer a:
the adjustments for operating leases would inrease the amount of total debt in the debt-equity ratio thus increasing the ratio; the estimated lease interest expense would lower the interest coverage ratio
it sounds to me like my answer was correct
 
CFALondon
I believe Off Balance Sheet Liabilities like Operating Leases are entered into by companies in order to do the following:
1. Make Debt to Equity Lower.
2. Current Ratio Higher
3. Interest Coverage Ratio Higher.
So the Analyst would have to
a. Include the Operating Lease expense as Debt – So this would increase the D/E ratio.
b. Increase the Interest expense (treat this for analysis purposes as though it were a capital lease – so portion of the Rent expense becomes Interest expense) –> so the Interest Coverage ratio gets lower.
This is my belief. Hopefully Super I or HiredGuns or someone else will offer more insight.
CP
 
Your answer was wrong because the question asked for HIGHER for…
Interest Coverage got lower. This is a TRICK that CFA has played very often in these 2 by 4s.
Debt / Equity Higher <– YES
Interest Coverage Lower <— NO
CP
 
Capital leases are added to assets and liabilities and then depreciated….and the current payment is seperated into principal and interest…thus interest expense is higher for a capital lease so EBIT/Interest is lower? Is this correct?
The interest expense shows up on CFO so CFO is lower for a capital lease and the principal payment shows up on CFI or CFF?
 
askajan, CFO is higher for a capital lease than an operating lease because CFO is reduced only by the interest paid, whereas in an operating lease, it is reduced by the entire lease payment. The only better ratios for capital leases are CFO and Interest Coverage (because EBIT is higher).
 
Finance03, are you sure that the interest coverage ratio is better with a capital lease? EBIT is higher by the amount of interest, but interest expense is higher by that same amount. I think the result is that the interest coverage ratio decreases with a capital lease, and is thus worse than with an operating lease.
 
Yes, please disregard my prior post, I was incorrect!
The only two ratios that are better (in the early years) are CFO and EBIT.
 
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