Operating Leases:
Skewing Financial Analysis
By Cindy Moorhead
Moorhead Management Services

Key ratios used in conventional financial analysis may be inaccurate for a company that has large operating leases. In the U.S., a lease that meets certain accounting rules is considered an operating lease. Operating leases are not capitalized as an asset and liability on the balance sheet, but rather, are shown just as an expense on the income statement. Information about operating leases can be found in the footnotes and footnotes are only in audited financial statements.

I was recently involved with the analysis of a Financial statement for a retailer who extensively utilized operating leases. This company had a very low debt to equity ratio which might lead one to conclude their leverage was low. However, the bond rating company considered this account very highly leveraged. After calling the analyst at the bond rating company I found that, as a conservative analysis of risk, the bond rating company revised leverage calculations to incorporate the risk from operating leases.

Here are some points to be aware of when analyzing a customer with large operating leases:

• The assets financed and the debt involved with an operating lease are not included in the balance sheet.

• Future amounts owed as lease commitments are recorded only as a footnote to audited financial statements.

• Since operating leases are not capitalized, the debt to net worth of your customer will be understated when doing conventional ratio analysis.

• A company with large operating leases, on a comparable basis with other companies, will tend to have higher net income in early years and lower net income in the later years.

There is another risk to consider should your customer file for bankruptcy in the U. S. Damage awards on rejected real property (land and building) leases (which could include operating leases) may be quite high. If the bankruptcy court accepts the operating lease contract, all past due amounts will be brought current. If the contract is rejected, they could provide the lessor with a claim against the bankrupt company for the lesser of 15% of the total future minimum lease amount to be paid or three years' rental. This could be a large bankruptcy claim if your customer has extensive use of operating leases for their real property.

Special analysis must be taken into account for customers with operating leases. The financial impact of operating leases on the company's financial strength must be considered to effectively analyze these accounts.

Cindy Moorhead is owner of Moorhead Management Services. She specializes in training credit departments to spot red flags in customer financial trends. Her email is cindy@moorheadmgmt.com. Her website is www.moorheadmgmt.com. Her e-mail is cindy@moorheadmgmt.com

Reprinted by permission from Trade Vendor Quarterly
Blakeley & Blakeley LLP Winter 02