If you were to adjust an interest coverage ratio for the effects of an operating lease, why would you add back a “rent expense” to EBIT?
I think you mean for effect of Capital lease
No, it says op lease. Do you think this is a typo?
It’s probably a typo, because I only know to adjust interest expense for Capital Lease.
It may be that they want to reclassify the lease as debt and add the interest expense as it would be included as a capital lease, increasing EBIT. Since we readjust operating leases as debt, this would make sense for banks when looking at ratios. I know we treat operating leases as debt.
Correct me if I’m wrong, but… The basic point is that you’re converting the rent into interest. Since your original EBIT includes a deduction for rent (i.e. earnings before interest and taxes, but after rent, which is an operating expense), you need to adjust for that. Current situation: -5 (rent expense) -10 (interest) 20 (EBT) 30 (EBIT) 100 (assets) 40 (liabilities) 60 (equity) Interest coverage: 30/10 Let’s say that the op lease is equivalent to owning the asset (worth $50), and taking on debt (also $50) with $5 annual interest. New situation: 0 (rent expense) -15 (interest) 20 (EBT) 35 (EBIT) 150 (assets) 90 (liabilities) 60 (equity) Interest coverage: 35/15
Yes it is an advantage of an operating lease, though it is treated financially as debt, it is not on the balance sheet and therefore dilutes the EBIT/I when added back.