Dear All- Why is debt / asset and debt / equity ratios higher for finance leases as compared to operating leases.
In case of D/A, assets have increased and in case of
D/E. equity (Asset- liability) has remained constant as both asset and liabilities have increased
Your help will be appreciated
Because Assets are typically larger than Liabilities, so when you increase both the numerator and the denominator by the same amount in the case of D/A, you get an increase in the ratio.
For D/E, equity is unchanged most of the time, except in a sales-type lease. But even then it almost always increases as well.
Whenever one of my candidates has a question about ratios in general, I encourage them to create an example with real numbers and see what happens.
Here, I’d start with:
- Assets = 10
- Liabilities = 6
- Equity = 4
Then add a capital lease with a value of 1:
- Assets = 11
- Liabilities = 7
- Equity = 4
Compute L/A and L/E in both cases and you’ll see immediately what has happened.
Once again, I decided to post a question under here instead of starting an entirely new thread (not sure if that’s proper forum etiquette or what).
Anywho, my question is concerning finance leases. To my understanding, under IFRS, if I am a lessee with a finance lease I report the following on my financial statements:
Balance Sheet = leased asset + lease payable
Income Stmt = interest expense + depreciation
Cash Flow Stmt = operating outflow of interest expense; financing outflow of lease expense
My question: For the cash flow stmt, is depreciation part of the lease expense for the financing outflow?
Depreciation is noncash, so it doesn’t appear on the cash flow statement.
I understand that depreciation is non cash. What I don’t understand is why it is not included in the cash flow stmt concerning leases. Whereas other depreciation is included in the operating section of the cash flow stmt.
Depreciation per se doesn’t appear on the statement of cash flows.
If you calculate CFO via the indirect method, you add back non-cash expenses, such as depreciation, but that’s only because it was subtracted to arrive at net income. If you calculate CFO via the direct method, depreciation never appears.
The depreciation will be depreciation on owned assets and (financial) leased assets.
Thank you for the thorough explanation. The distinction between the direct and indirect methods really drove it home for me. I appreciate your help.