CreditStats- Operating Lease Analytical Model

Analyst:

David Lugg, New York (1) 212-438-7845

Publication date: 13-Aug-02, 14:50:45 EST

To improve financial ratio analysis, Standard & Poor's uses a financial model that capitalizes operating lease commitments and allocates minimum lease payments to interest and depreciation expenses. Not only are debt-to-capital ratios affected, but so are interest coverage, funds from operations to debt, operating margins, and return on capital. This technique is superior to the more commonly used "factor method," which multiplies annual lease expense or rent by a factor reflecting the average life of leased assets.

The operating lease model is intended to make companies' financial ratios more accurate and comparable by taking into consideration all assets and liabilities, whether they are on or off the balance sheet. In other words, all rated firms are put on a level playing field, no matter how many assets are leased. The model also helps improve analysis of how profitably a firm employs both its leased and owned assets. By adjusting the capital base for the present value of lease commitments, the return on capital better reflects actual asset profitability.

Using the Methodology

The lease analysis model is fairly straightforward. As shown in the example, lease commitment data for a firm are gathered from the notes to its financial statements. Annual data for the first five years, or 2001 to 2005 in the example, are set forth in the notes. For the remaining lease years, the model assumes the lease payments approximate the minimum payment due in year five, or 2005, below. The number of years remaining under the leases is simply the amount "thereafter" divided by the minimum fifth-year payment. The result is rounded to the nearest whole number. The present value of this payment stream is then determined using a discount rate. Standard & Poor's uses a 10% discount rate because the implicit lease rates are rarely disclosed.

Table 1 Lease Model Calculation
Reported figures: Future minimum lease commitments (mil. $)
	Reporting year
Payment period	2000	1990
Year 1	106.4	103.5
Year 2	99.4	94.6
Year 3	89.7	85.4
Year 4	77.5	77.2
Year 5	71.8	66.3
Thereafter	404.3	414.2
Total payments	849.1	841.2

Table 2 Calculation of Net Present Value for 2000
Future minimum lease commitments (mil. $)
2001	106.4
2002	99.4
2003	89.7
2004	77.5
2005	71.8
2006-2011	67.4
Interest rate assumption	10%
2000 net present value (NPV)	526.0
1999 NPV	517.1
2000 implicit interest	Avg. NPV ($521.5) x interest rate (10%) = $52.2
Lease depreciation expense	Adjustment to SG&A (see below) - implicit interest = $105.0 - $52.2 = $52.8
Adjustment to SG&A--rent	Avg. first-year min. payments ($106.4 + $103.5)/2 = $105.0.
SG&A--Selling, general, and administrative expenses.

Table 3 Sample Calculation Results
	Without capitalization	With capitalization
EBIT interest coverage (x)	6.8	3.3
EBITDA interest coverage (x)	8.6	4.0
Return on capital (%)	31.2	22.5
Oper. income/sales (%)	15.2	21.2
Free oper. cash flow/total debt (%)	164.5	52.6
Funds from operations/total debt (%)	98.3	34.4
Total debt/capital (%)	25.6	55.5

The resulting present value figure is added to reported debt to calculate the total-debt-to-capital ratio. The figure is also added to assets to account for the right to use leased property over the lease term. Although less than the cost of the property, this adjustment recognizes that control of the property creates an economic asset.

The implicit interest is calculated by multiplying the average net present value of the current and previous years by 10%. This figure is then added to the firm's total interest expense. The SG&A adjustment is calculated by taking the average of the first-year minimum lease payments in the current and previous years. SG&A is then reduced by this amount. Depreciation expense is calculated by subtracting the implicit interest from the SG&A adjustment. The lease depreciation is then added to reported depreciation expense. The interest and depreciation adjustments attempt to allocate the annual rental cost of the operating leases. There is ultimately no change to reported net income as a result of applying the lease analytical methodology.

Financial Ratio Effect

EBIT.

The implicit lease depreciation and amortization adjustment is added to D&A expense; the adjustment to SG&A expense reduces SG&A expense. The result is to increase EBIT by the difference between the implicit lease D&A and SG&A adjustments, $52.2 million, which is also the amount of the implicit interest.

EBITDA.

In this case, only the implicit interest is added to EBITDA (see note below). The result is that EBITDA is increased $52.2 million.

Interest expense.

The implicit interest figure, $52.2 million, is added to total interest expense incurred.

Total debt.

The net present value of lease payments, $526 million, is added to total debt.

Operating income before D&A.

Standard & Poor's typical calculation for the operating margin adds D&A back to operating income. When the operating lease adjustment is made, operating income is increased by the adjustment to SG&A expense, $105 million.

Funds flow.

Funds from operations is increased by the implicit lease depreciation expense, $52.8 million.

Change in Methodology

Standard & Poor's has revised how it applies the operating lease adjustment to the calculation of EBITDA. It was noted that by adding implicit D&A to EBITDA, the previous methodology was recasting a cash expense (rent) as a non-cash charge. Given the wide use of EBITDA as a proxy for cash flow, this recasting was deemed inappropriate.

This change, by reducing adjusted EBITDA, lowers EBITDA interest coverage measures and increases leverage measures such as total debt to EBITDA. In the example above, EBITDA interest coverage is now 4.0 times (x), whereas it would have been 4.6x using the old methodology.

As always when implementing a technical change such as this, Standard & Poor's will not change any ratings solely on the basis of the new calculation.