In this tutorial, you’ll learn how accounting rule changes in 2019 around Operating Leases impact financial statement analysis and valuation, and what to do when calculating metrics such as Enterprise Value.

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Table of Contents:

0:49 The Short Answer

4:33 Changes on the Financial Statements

8:40 Examples for Target and EasyJet

11:48 Valuation Multiples and Metrics

15:50 Recap and Summary

Under both U.S. GAAP and IFRS, companies now report Operating Leases as Liabilities on their Balance Sheets, along with “Right-of-Use” Assets corresponding to them on the Assets side.

Under U.S. GAAP, companies still record Operating Lease Rent as an Operating Expense on the Income Statement.

Under IFRS, companies now split the old Rental Expense into Depreciation + Interest components on the Income Statement.

Under IFRS, on the Cash Flow Statement, Cash Flow from Operations will increase due to the additional Depreciation, but Cash Flow from Financing will fall due to the “Repayment of the Capital Element of Operating Leases,” which offsets Depreciation.

Under U.S. GAAP, nothing about the Cash Flow Statement changes.
Despite these changes, most companies’ Net Income and Net Change in Cash figures barely change! It’s still the same total expense, just presented differently.

In valuation, you can add Operating Leases to calculate Enterprise Value, but if you do so, then you must then exclude all lease-related expenses on the Income Statement in the denominator, in metrics such as EBIT and EBITDA.

Under U.S. GAAP, effectively, you must use EBITDAR if you count Operating Leases as Debt in the TEV calculation.

If you do not count Operating Leases as Debt in TEV, then you can use traditional metrics like EBIT and EBITDA and pair them with TEV.

Under IFRS, you can’t really use EBIT anymore, and when you use EBITDA, you need to pair it with a TEV metric that includes Operating Leases. Also, EBITDA and EBITDAR are now effectively the same.

For returns-based metrics, such as Return on Invested Capital (ROIC) and Return on Capital Employed (ROCE), the treatment gets a bit tricky because companies define them slightly differently.

However, both ROIC and ROCE typically use NOPAT, or Net Operating Profit After Taxes, in the numerator, and then Invested Capital or Capital Employed in the denominator.

Invested Capital or Capital Employed are usually defined as Average Shareholders’ Equity + Average Debt – Average Cash + Average Operating Leases.

For historical periods in which the leases are not yet on the Balance Sheet, you can capitalize them manually by multiplying the rental expense by 7x or 8x.

If Invested Capital or Capital Employed are defined like that, then the Operating Income number you use to calculate NOPAT must exclude the Interest Element of Operating Leases now – even if the company follows U.S. GAAP!

So, the company will have to split out a portion of its Rental Expense and count it as an “add-back” to remove the Interest Portion of the lease expense. You can see an example of this in Target’s filings.