Capital vs Operating lease for a lessee

Here are the general rules for a lessee for a capital vs operating lease capital lease Operating lease Assets H L Liabilities H L Net Income (early) L H Net Income (late) H L EBIT (operating income) H L CFO H L CFF L H Asset ratios L H Debt ratios H L I understand your assets and liabilities are higher in a capital lease, but i cant for the life of me find an easy way to remember the rest of the rules as they dont really make sense to me. Appreciate anyone who has a quick fire way of remember this, or can explain in short sentences. Thanks

I go about this as In the case of a Capital Lease there is both a Short term Liability (CL) due in this year and a Long term Liability. So Liability is Higher --> basically Debt is Higher so D/E Higher. Assets are higher as well, because PV(MLP) gets added to assets. Once Assets goes up, we have a couple of effects to consider. a. We would definitely have higher Depreciation Expense. So in the initial years – NI Would be Lower. NI Lower means in the initial years – ROA would be Lower. b. Assets are higher, so Asset Turnover would be lower. c. As the asset gets depreciated over the life of the lease, you would have the higher revenues because of the use of the asset kicking in, constant depreciation --> so higher NI in later years. EBIT = Revenues - COGS - Expenses. Expenses in a Operating Lease would he Higher – because the Entire Lease expense is a rental expense. So EBIT in a Operating Lease would be LOWER. At the time of calculation of EBIT no other expenses have thus far come in an a Capital lease (due to the Lease) – so EBIT in a Capital Lease is HIGHER. Another factor to be aware of: In the early years of a Capital Lease: Interest Expense + Depreciation Expense > Lease Rental Expense for a Operating Lease. So that would cause NI in a Capital Lease to be lower than in a Operating Lease. As time goes on, Interest expense progressively reduces and the entire effect reverses. HTH CP

i don’t think there’s a quick way of explaining it unless you just want to straight memorize. i think you need to know and understand the details. if you’re interested in the details: think about what lease expense is for an operating lease: the entire payment is expensed, before EBIT, and goes out through CFO. that means EBIT and CFO will be lower for operating leases (NI is different see below). keep in mind that this lease payment is constant over the lease. operating: capital: Gross Profit Gross Profit -lease expense less: interest exp (which is less than operating lease exp) EBIT EBIT -depreciation NI lease expense for a capital lease: you now have an asset and liability, so there will be a few things going on: depreciation expense, interest expense, and principal payments. all of these are changing over the life of the lease due to changes in the asset/liability amounts so take the time to think about when the asset/liability is large, how that affects int exp/depreciation/principal. at first, you have a big asset & liability which means interest expense and depreciation expense (except SL dep) are at their highest. interest expense goes out through CFO and principal payments go out through CFF. additionally, the depreciation expense does not reduce EBIT but reduces NI. however, near the end of the lease term, the asset and liability amounts will be lower, which means lower interest expense and lower depreciation (assuming not SL). one thing you really have to remember is that the interest expense on the capital lease isn’t as much as the total lease expense on the operating lease so EBIT will be higher for capital. that was as short as i could do it, sorry.

Another way to remember it is that in the early years ratios and financials are generally worse under a capital lease, except for operating income and cash flow from operations.

shoot my accounting chart should have looked like this: operating: Gross Profit less: lease expense EBIT Capital: Gross Profit less: interest exp (which is less than operating lease exp) EBIT less: depreciation NI

Interest expense should come after EBIT–> Earnings BEFORE Interest and Taxes, right…

shoot again

I believe Sales -COGS+Expenses=EBITDA Less Depreciation, Amortization EBIT Interest EBT Taxes NI

absolutely brilliant thoughts. Thanks guys.

Another way to think about it, is the only benefit in capitalising a lease is CFO inc and EBIT inc. Everything else Assets, Liabilities, asset ratios, leverage ratios, Net income are all bad for a company that capitalises. Hence, its beneficial to have an operating leases for the most part.