Finance lease vs. operating lease

CFA Level I FRA
#1

Company A goes with a finance lease as opposed to a operating lease. The effect on their current ratio and debt/equity when compared with an operating lease: Answer: Current ratio: decrease Debt/equity: decrease

Operating lease D/E ratio is 50/100 = 50%

Finance lease D/E ratio is (50+10)/(100+110) = 55%

~OR~

Operating lease D/E ratio is 100/50 = 200%

Finance lease D/E ratio is (100+10)/(50+10) = 186%

So dpending on the leverage, isn’t it possible that the addition of the euqal amounts of debt and equity could reduce the D/E ratio compared to an operating lease?

#2

Your question isn’t clear.

Financing leases increases assets and liabilities on the balance sheet, therefore driving up D/E ratios.

Operating leases artificially inflate ROA and ROE.

#3

I wrote a series of articles on leases, including this one on the effects on financial statements and ratios: http://financialexamhelp123.com/leases-iii-effect-on-financial-statements-and-ratios/.

Under a finance lease, the current ratio will decline because there is no increase in current assets, but there is an increase in current liabilities: the current year’s lease payment. The debt-to-equity ratio will increase because liabilities increase while equity is unchanged.

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#4

The answer states that the D/E ratio will always increase.

If debt is less than equity (100/200) = 50%

an increase in debt and assets (110/210) = 52%

But if we deal with the inverse, where debt is greater than equity (200/100) = 200%

an increase in debt and assets (210/110) = 190%.

Thus (or so I think) depending on how much debt to equity you have, an equal increase in debt and equity can either increase or decrease that ratio. Does that make any sense?

Thanks for the response!

#5

Why is equity unchanged?

In a semi-related question regarding DTA/DTL and it’s effect on liabilities-to-equity; the problem says that an increase in DTL by 10 and DTA by 5 increases the ratio. Wouldn’t the DTA be a part of equity?

#6

When you enter into a finance lease, you record an asset and a liability, each in the amount of the present value of the minimum lease payments. Higher assets, higher liabilities.

There is no effect on equity at the inception of the lease.

In the early years of the lease, the expenses under a finance lease will be higher than those under an operating lease, so net income will be lower, so equity will be lower; in fact, equity will be lower under a finance lease for the entire life of the lease; only at the end of the lease will equity be equal to what it would be under an operating lease.

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#7

Perhaps it is a stupid question, but why don’t the proceeds inrease equity?

#8

There are no proceeds, a lease is a debt you incurr. You make periodic payments, and not revenue.

#9

Are you, perhaps, interpreting the question as being about the lessor? They’re the party that receives proceeds from a lease.

This question is about the lessee. They make the payments; they don’t receive payments.

#10

No. I’m just curious as to why a finance lease doesn’t increase assets when you record an asset and liability on the balance sheet. My understanding of a finance lease is, that because you record it on your balance sheet (and depreciate it) you own it. Thus, you treat it as an asset.

#11

MrSmart wrote that you increase assets and I wrote it twice (see above).

Assets increase and liabilities increase by the same amount. Equity doesn’t change.

#12

Looks like I’ve celebrated a bit too hard today. Thanks.