Question About Finance Leases

CFA Level I FRA
#1

So in the Schweser book it says (pg. 270 of FRA book): “Most importantly, leverage ratios, such as the debt-to-assets ratio and the debt-to-equity ratio, will be higher with finance leases than with operating leases because of the reported liability.”

OK, but I thought equal amounts were added to both assets and liability, so I don’t understand how the debt to assets ratio would increase.

For example, a $200,000 lease to a company with reported debt of $500,000 and assets of $250,000 will change the debt to assets ratio like this (at least this is what I think):

Without Lease --> 500/250 = 2

With Lease 700/450 = 1.55

doesn’t it actually lower the D to A ratio? Because if there was an operating lease, the D/A would remain unchanged at 2.

Hopefully someone has a discussion point about this one, appreciate any and all responses. Thanks!

#2

Because x/y = 1 as both x and y go to infinity.

Why would a company have more debt than assets? The ratio is almost always less than 1.

#3

oh that’s right that’d signify negative equity. Woops. Now it makes sense. Brainfarted there, thanks for the answer MrSmart

#4

I believe the Schweser assumes the D/E or D/A ratio is less than 1, meaning an equal increase in both would increase the D/E ratio.

Ex: D/E = 1/2 = .5

After lease: D/E = 2/3 = .66

Likewise applies when debt/assets is less than 1. A company with more debt than assets means that there is negative shareholder equity.

#5

I don’t think Shweser is assuming that D/E and D/A are less than 1. A=L+E which means A > L & A > E so D/A IS below 1. As for D/E it is possible to be below or above 1 but think about it this way:

In early years, depreciate and interest expense(financial lease) > Lease payment ( operating lease) which means less Net Income and subsequently less Equity (through retained earning). so less equity --> higher debt-to-equity ratio.

#6

Good Point