capital lease and operating lease

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hw0799's picture

when consider interest rate coverage ratio, why operating lease could overestimated it?

I think using operating lease will have lower net income that capital lease, is it?
also, cpaital lease will increase interest expense ?

if so, how to quantify the increase of income can not catch up the increase of interest expense in the case of capital lease.

confusing.

interest converage ratio=NI/interest expense

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chebychev's picture

An operating lease could overestimate your definition of interest coverage for two reasons: one, interest expense is lower under an operating lease because no portion of the lease payment is interest expense; and two, net income is higher under an operating lease in the early years because lease expense is simply the lease payment, rather than the sum of depreciation of the asset and interest expense (as in a capital lease).

However, I believe interest coverage is more typically calculated as EBIT/interest expense. Here the analysis may be more confusing because the effect on the numerator and denominator may point in different directions. EBIT may be lower with an operating lease if the entire lease payment is deducted in arriving at EBIT but, under a capital lease, interest expense is not deducted in arriving at EBIT. Interest expense will be lower under an operating lease for the reasons identified in the first paragraph. So under this definition, the numerator and denominator both increase when considering a capital versus operating lease. But since the numerator (EBIT) is typically larger than the denominator (interest expense), the net effect is that the addition to both the numerator and the denominator lowers the ratio (consider that 50/5 = 10, while 55/10 = 5.5). In other words, even with the revised definition of interest coverage, opeating leases can cause it to be overestimated.

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