The impact of lease accounting on financial statements is substantial. Financial ratios are important tools used in accounting and financial analysis to gauge a company’s overall financial health. They are derived from financial statements like the balance sheet, income statement, and cash flow statement. These ratios can help in assessing various aspects of a business, such as its liquidity, solvency, profitability, and operational efficiency.
To evaluate the impact of leases on the financial ratios of a company, one needs to understand how they affect the company’s income statement, balance sheet, and cash flow statement. For example, the inclusion of lease liabilities and ROU assets on the balance sheet can impact various financial ratios and metrics. ROU is now a very important aspect of lease accounting within the parameters of the new lease accounting standards. This asset now encapsulates the details of how a lessee is allowed to use an asset if it is cited in a lease throughout a contract. Debt ratios, such as debt-to-equity and debt-to-assets, are likely to increase due to the addition of lease liabilities.
Current Ratio: Current Ratio: The current ratio is a liquidity ratio that measures a company’s ability to cover its short-term obligations with its current assets. With the inclusion of the current portion of lease liabilities, the current ratio generally decreases. The reduction in the current ratio post-accounting change may not necessarily mean a reduction in operational liquidity but could raise questions among creditors.
Debt Ratios: Debt ratios, such as debt-to-equity and debt-to-assets, are likely to increase due to the addition of lease liabilities. Similarly, metrics like return on assets (ROA) and return on equity (ROE) could experience fluctuations due to changes in both assets and liabilities.
Debt-to-Equity Ratio: The debt-to-equity ratio is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets. Accounting for leases on the balance sheet increases total liabilities, thereby increasing the Debt-to-Equity ratio. This ratio is closely related to leveraging, the ratio is also known as risk, gearing, or leverage. Although the accounting change increases this ratio, investors and lenders need to note that the underlying economics have not changed—only the accounting representation has. Therefore, the perceived additional risk may not be real.
Interpretation of Ratio Changes in Leasing Industries
EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), is an alternate measure of profitability to net income. By excluding depreciation and amortization as well as taxes and debt payment costs, EBITDA attempts to represent the cash profit generated by the company’s operations. The increased EBITDA post-change might give a false sense of security regarding a company’s earnings quality. Investors should examine other metrics and the details of the financial statements to get a fuller picture.
Operating Cash Flow to Total Debt Ratio: The cash flow-to-debt ratio is the ratio of a company’s cash flow from operations to its total debt. This ratio is a type of coverage ratio and can be used to determine how long it would take a company to repay its debt if it devoted all of its cash flow to debt repayment. While the ratio improves on paper, creditors should assess whether this improvement truly represents a change in the company’s ability to meet its debt obligations or is merely an accounting artifact.
Cash flow Statements: The cash flow statements show how a company’s cash inflows and outflows are generated from its operating, investing, and financing activities. The new lease accounting standards also change how a company reports its cash flow from leases, as they need to separate the principal and interest payments for both operating and financing leases. Each lease payment is allocated between the reduction of the lease liability and interest expense. This could experience fluctuations due to changes in both assets and liabilities and income and expenses statements. Therefore, knowing how leases affect a company’s cash flow statements and how they reflect cash flow generation and management is important.
Impact on Investors and Creditors:
For investors, these ratios can signal the attractiveness of a potential investment. Creditors may use them to determine a company’s creditworthiness, while management teams use financial ratios for strategic planning and decision-making. Given their crucial role, any change in the accounting standards that influence these ratios can significantly affect the perception of business health and success. With a clearer view of lease obligations, investors and creditors better understand an organization’s financial risk and stability.
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