Operating Lease
A lease that under IFRS 16 and ASC 842 now sits on the balance sheet as a right-of-use asset and a lease liability. Whether to treat that liability as debt in the EV bridge is a live judgement: it is a contractual fixed obligation, but treating it as debt while leaving lease costs inside EBITDA double-counts. Pick one treatment, apply it to every company in the comp set, and say which you chose.
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Where operating lease sits in the three statements
- Rent (old treatment): £10m, now nil
- Depreciation of right-of-use asset: +£8.66m
- Interest on lease liability: +£2.16m
- Right-of-use asset: £43.3m, less £8.66m a year
- Lease liability: £43.3m, then £35.46m
- Lease principal repaid (financing): −£7.84m
What moving it does
A five-year lease at £10m a year paid at each year end, discounted at 5%. The present value of the five payments is £43.3m (£10m times 4.3295, the five-year annuity factor at 5%). Year one, under IFRS 16, against the old rent accounting.
| Statement | Line | Effect |
|---|---|---|
| Balance sheet | Right-of-use asset and lease liability | +£43.3m each on day one. Assets and liabilities up by the same amount; equity untouched. |
| Income statement | Rent | Gone. The £10m no longer appears as an operating expense, so EBITDA is £10m higher. |
| Income statement | Depreciation | +£8.66m a year: £43.3m straight-line over five years. |
| Income statement | Interest | +£2.16m in year one: 5% of the opening £43.3m. Falls each year as the liability is paid down. |
| Income statement | Profit before tax | Down £0.82m in year one: £8.66m plus £2.16m is £10.82m against £10m of rent. By year five the interest is small and the charge is under £10m; over five years the total is £50m either way. |
| Balance sheet | Lease liability | Opening £43.3m, plus £2.16m of interest, less the £10m paid: £35.46m at the end of year one. |
| Cash flow statement | Cash from operations | +£7.84m: the £10m paid is now £2.16m of interest (kept in operations here) and £7.84m of principal, and the principal moves to financing. |
| Cash flow statement | Financing | −£7.84m of lease principal. Net change in cash: nil, as before. |
The close. End of year one: right-of-use asset £34.64m (£43.3m less £8.66m), lease liability £35.46m, retained earnings down £0.82m. The asset is £0.82m short of the liability and equity is down £0.82m: balanced. The cash paid was £10m in both worlds. What changed is where the £10m appears, and that EBITDA, net debt and operating cash flow all rose without a pound moving differently.
What the footnote discloses
In the note
- A maturity analysis of undiscounted lease payments: within one year, one to five, beyond five. This is the schedule that lets you rebuild the liability at a different rate.
- The discount rate used, or the range, and the total cash outflow for leases in the year.
- Short-term, low-value and variable lease payments expensed outside the liability, which for a retailer with turnover rents can be a large number.
- Extension and termination options not included in the liability, and the assumptions behind them.
What an analyst does with it
- Decide the convention before the comp set is built: either lease liabilities in net debt with an IFRS 16 EBITDA, or leases out of net debt with an EBITDA after rent. Then apply it to every company, converting the US GAAP ones with the note.
- Rebuild the liability from the maturity table at a common discount rate when comparing across companies, since each uses its own incremental borrowing rate.
- Add variable and short-term lease payments back into a true rent figure. A lease liability that excludes them understates the fixed cost base of a business whose rents are mostly turnover-linked.
- For leverage covenants and credit, read the definition in the facility agreement. Most written since 2019 freeze the accounting at pre-IFRS 16, so the reported ratio and the covenanted ratio are different numbers.
The interview question it becomes
- “How did IFRS 16 change EBITDA, EBIT and net debt for a retailer, and what do you do about it in a valuation?”
- EBITDA rose by the rent, because rent became depreciation and interest, both below it. EBIT rose by the interest part only, since depreciation sits above EBIT. Net debt rose by the lease liability, the present value of future rents. In a valuation you keep the pair consistent: an IFRS 16 EBITDA with the lease liability in net debt, or an EBITDA after rent with leases out of debt. Either is defensible; mixing them is not.
- The follow-up: “A US-listed peer reports under US GAAP. Same multiple?”
- The catch is comparing the two EBITDAs as if they were the same figure. Under ASC 842 an operating lease keeps its rent in operating expenses, so the US peer’s EBITDA is lower by the rent while its lease liability is on the balance sheet too. The strong answer converts one side: add the US peer’s lease cost back to reach an IFRS-style EBITDA and put its liability in net debt, or take the IFRS company’s depreciation and interest out and leave its liability out. The point the interviewer is waiting for is that the liability and the rent must not both count.
Why Operating Lease matters in interviews
IFRS 16 and ASC 842 moved most leases onto the balance sheet in 2019, and they did it differently, which is why the same retailer can show a different EBITDA, a different net debt and a different leverage ratio depending on which set of accounts you open. The question is a favourite because it forces three things at once: what the standard did, what it did to each statement, and what you then do about it in a valuation. Candidates who know the first and not the third are common.
How it works in practice
Under IFRS 16 every lease over twelve months, other than low-value items, puts a right-of-use asset and a lease liability on the balance sheet. The liability is the present value of the remaining payments at the rate implicit in the lease or the lessee’s incremental borrowing rate. The income statement no longer shows rent: it shows depreciation of the asset and interest on the liability, both below EBITDA.
Under ASC 842 the balance sheet treatment is the same but an operating lease keeps a single straight-line lease cost in operating expenses, so EBITDA is unchanged from the old world. Only finance leases split into depreciation and interest. This is the difference that matters in a cross-border comp set.
The IFRS 16 charge is front-loaded. Interest is highest when the liability is largest, and depreciation is flat, so the total charge exceeds the rent early in a lease and falls below it late. For a company with a stable portfolio of leases at different ages the effect washes; for a young estate it depresses profit.
Cash is unchanged by any of this. The rent still leaves. Under IFRS 16 the principal part of it is presented in financing and the interest in either operating or financing, so operating cash flow rises by most of the rent, which is the other half of why EBITDA and cash conversion both look better than they did.
What candidates get wrong
- Adding the lease liability to net debt while using a US GAAP EBITDA that still carries the rent, or an IFRS EBITDA from before 2019. The obligation is then counted twice: once as a cost inside the multiple, once as debt in the bridge.
- Comparing an IFRS reporter’s EBITDA with a US GAAP reporter’s without adjusting one of them. The gap for a retailer or an airline can be a third of EBITDA.
- Reading the rise in operating cash flow in 2019 as an improvement in the business.
- Treating the liability as a fixed number. It is a present value, so it moves with the discount rate, and it excludes variable payments, options not reasonably certain to be exercised, and short-term leases.
Operating Lease: frequently asked questions
What did IFRS 16 change?
It put operating leases on the balance sheet as a right-of-use asset and a lease liability, and replaced the rent expense with depreciation and interest. EBITDA went up by the rent, net debt went up by the lease liability, operating cash flow went up by the principal part of the rent, and cash itself was unchanged.
Is a lease liability debt?
It is a fixed contractual obligation with an interest rate, so for credit purposes yes. For an EV bridge the answer depends on the EBITDA you are pairing it with: an IFRS 16 EBITDA has already stripped the rent out, so the liability belongs in net debt; a US GAAP operating-lease EBITDA still carries the rent, so it does not. Pick one convention for the whole comp set and say which.
What is EBITDAR?
EBITDA before rent. It was the tool for comparing lessees with owners before IFRS 16 and it is still the tool for comparing an IFRS reporter with a US GAAP one: add the rent back to the US GAAP figure, or add the lease cost back to the IFRS figure, and the two are on the same basis.
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