Debt-to-Asset ratio on finance lease

As per schweser, the debt-to-asset ratio is higher with finance lease than with operating lease because the liability is reported on balance sheet in finance lease.

I do not completely get this point. In case of finance lease, both Asset and Liability increases. So in case of debt-to-asset ratio, both numerator and denominator are increasing by same amount. So how can we say the ratio is always increasing.

We make a wild assumption here: equity is positive.

If so, then the same (dollar) increase in assets and debt is a greater percentage of debt than of assets; thus, debt-to-assets increases.

Try it with some simple numbers. First, without a finance lease:

  • Assets = 10
  • Liabilities (all debt) = 6
  • Equity = 4
  • D/A = 6/10 = 0.6

Next, with a finance lease whose value is 1:

  • Assets = 11
  • Liabilities = 7
  • Equity = 4
  • D/A = 7/11 = 0.64

Only if debt = assets will the ratio remain unchanged, and only if debt > assets will the ratio be smaller when a finance lease is added. Neither possibility will occur on the CFA exam (and neither will likely occur in the real world; at least, not for any sustained period of time).

make sense, Thankyou Sir.

My pleasure.