Share Sleuth's notepad: Finding hidden debt

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Without shops, a high street retailer has no business. Without planes, an airline can't fly. Whether a company chooses to lease the assets, or buy them outright, the risks are similar, but the accounting is different, and that can have a big impact on the appraisal of profitability, financial strength, and value.

Not for the first time, a reader has asked me how I account for operating leases. Let's start with why. 

Operating leases aren't reported on a company's balance sheet. Rent, the lease payment, is charged against the income statement like any other cost, electricity say. But if, for example, a retailer closes a shop it can switch off the lights and stop paying for electricity. It can't stop paying rent. Operating leases are contracts, which commit the leasee to payments for a minimum term, often five, ten, fifteen years or more.

It the retailer wants to close a shop it may be able to sublet it, which may not raise enough to pay the rent in full, or sell the lease, which may not raise enough money to fund the retailer's liability to the landlord. Its options are similar to those it would have had if it had borrowed money and bought the property. In that case it could let the property to cover the mortgage, or some of it, or sell the property to repay the mortgage, or some of it.

Since a shop, or a plane is obviously an asset, and the obligation to pay rent a liability, these items should be recorded on the balance sheet, and included in ratios used to calculate the levels of debt and profitability derived from it.

This is why investors and credit ratings agencies often capitalise operating leases, bringing them onto the balance sheet, and why the International Accounting Standards Board is changing the rules. That will make a lot of companies with large lease commitments look heavily indebted and less profitable than before so I imagine it's running into opposition. 

Progress appears to be slow. Rather commendably EasyJet, in consultation with shareholders, is unilaterally reporting return on capital employed adjusted for operating leases because it doesn't think the IASB will conclude its review until 2016 at the earliest.

Now for the how. I use a technique copied from credit ratings agencies and explained to me by @theredcorner66, a fellow blogger. It has all the virtues and vices of simplicity, which is essential because companies don't disclose much about operating leases. Often they reveal nothing in full-year results statements and bury scant details in the notes to the accounts in annual reports.

Simplicity is also useful to me because I look at many companies, and necessarily can only spend a relatively small amount of time on each.

The two sets of figures below are for WH SMith, the successful newsagent, stationer and travel retailer. The metrics I use are in green, and the adjustments for operating leases in pink. The left hand set is adjusted, the right hand side ignores operating leases: 


The idea is to treat the operating lease as an asset, as if the company borrowed the money to buy the right to use the property for a period and paid upfront. In that case it wouldn't pay rent, it would charge the same amount, the value of a lease is the present value of all the rent, in depreciation and interest to the profit and loss account. The adjustments are:

Line 4: Add back operating lease payments.

Line 5: Deduct the approximate value of depreciation, which is 67% of lease payments

These adjustments increase operating profit because depreciation is deducted from operating profit, and interest payments are not. 

Line 11: Add the approximate value of lease assets to borrowings using a multiple of eight times operating lease payments.

With the operating leases capitalised as debt, WH Smith goes from a net cash position to substantial net debt. 

Line 15: Add the approximate value of the leased assets to the operating assets of the company.

The additional capital now recognised in the accounts reduces return on capital from 40% to 8% and the inclusion of operating leases in net debt reveals a truer enterprise value [line 25]. Enterprise Value is the market's valuation of the whole business, which, when compared to profit [line 27], looks very generous for a newsagent and stationer - even a successful one like WH Smith. 

The calculation helps to answer three questions. Why, according to the usual statistics, some companies look absurdly profitable, financially indomitable, and cheap, yet turn out to be rather frail when they go bust (not my prognosis for WH Smith). The main liability, shops, is not on the balance sheet. 

I'm sure you're wondering where I get the eight times multiple and the 67%/33% split between depreciation and interest from. 

That's what you get if you assume the lease lasts ten years and interest is charged at 5%:

Let's say the lease asset is worth £1m. In the case of an asset that doesn't wear out like a building, it's the net present value of the rent earned by the landlord over the lease term. 

If the retailer borrows £1m at 5% a year to buy the right to use a shop for ten years and pays up front he would depreciate the value of the lease asset by £100,000 a year (1/10 of £1m) and pay interest of £50,000 a year (5% of £1m), a total cost of £150,000. The interest charge is one third of the cost (33%, £50,000/£150,000) and depreciation is two thirds (67%, £100,000/£150,000).

The net present value of ten annual payments of £150,000 is very close to £1.2m, which is eight times 150,000.

Of course companies lease assets over various terms and pay interest at various rates, so it's a generalisation. But for companies with large leases I think generalising is a lot less evil than ignoring the leases altogether.

Fortunately you only have to do the calculation once, and you can use the eight times multiple as a rule of thumb. 

I confidently predict that's raised more questions than answers. And that I'll be able to answer 33% of them, and be stymied by 66%.

Having launched this Thursday column in January as 'Diary of an Uncertain Investor', I've decided to re-christen it 'Share Sleuth's notepad'. That's not because I'm any less certain, far from it. It's just less of a mouthful, and a little less prescriptive.


On the blog this week:

  • Chemring: Responding to operational foul-ups and constrained defence spending, Chemring is making efficiencies. But profitable growth also depends on future levels of military activity.
  • Unilever: Unilever has put the long-term at the centre of its business plan. In the short-term the plan seems to be working, but it could have a negative effect on investors.


  • Wired: But no matter how big that data is or what insights we glean from it, it is still just a snapshot: a moment in time. That’s why I think we need to stop getting stuck only on big data and start thinking about long data.
  • Aswath Damodaran: Based on my estimates, and they could be skewed by my Apple bias, at its current stock price of $440, there is a 90% chance that the stock is under valued... It is a good test of whether you are a value investor...
  • Expecting Value: Something... makes a pound inside Cranswick worth a lot more than its assets are worth... They do things efficiently, management are competent, and they have the requisite structures in place to allow effective decision making. The next thing I have to do is swill with mouthwash, though; the last sentence is essentially nothing more than a list of platitudes you'd expect to hear from a bad boss.


I like this analysis. Which rating agency uses this method? thanks

Hi Philip, thanks for your comment. None of the ratings agencies do! It's been 'adapted' so that it fits the way I analyse a stock, and simplified still further. According to this overview, Moody's uses multipliers like I have, although it uses different multipliers for different industries:

Hi Richard,

Nice post.

However, there is one thing in your calculation i don't understand.
You gave an example of a simple 1m pound debt, but after converting it to operating lease you arrived back to a 'present value' of approximately 1.2m pound.
In my opinion you should have come to the 'true' PV of 1m pound, the value of the initial debt.

I think the reason for this is a small mistake in your calculation: you discounted the 'depreciation' sums instead of discounting the 'principle payment' sums (which according to your example there is only 1 principle payment of 1m pound at the end of the 10th year).

If you would've discounted the ten 50 thousands interest payments and the 1m pound principle payment at the end of the term, the PV/ payment multiple would've been 6.7 (1000/150).

But this multiple doesn't mean much as it is, because it relates only to the specific debt in your example.



Hi Michael, thanks for your comment.

I'm describing how the transaction would appear in a company's accounts if it borrowed £1m to use the property for ten years.

The interest charge would be £50,000 every year, and the asset would depreciate by £100,000 every year, so in the accounts the total cost over ten years is £1.5m. I'm discounting that total to a present value of £1.2m.

Hi Richard,

Thanks for the quick response, I hope you had a nice holiday! =]

The thing is that if you discount all the payments (principle and interest) of a £1m of debt you must get back to a present value of £1m, and it doesn't matter which cost of debt or maturity you use.

In your calculation you took a £1m debt, discounted it backwards, and received a PV of £1.2m, which is of course different than £1m.
The reason for this mistake is that you didn't discount the cash flow principle payments (which is only a 1 payment of the whole sum, £1m, at the end of the term, 10 yrs), but instead you've discounted the yearly depreciation sums of £100k. You should always discount only cash flows.

You can try and see that if you'd have discounted only the interest and principle cash payments as i described, you would've gotten back to a PV of presicely £1m.

The famous (and very not accurate) 8x multiple, is the outcome of specific set of debt, which is a 15 yrs to maturity with a cost of 6%.
This set of debt of course doesn't fit every for every company.

You can read more about it in the attached short report:




I'm using the PV method to validate the 8 x multiple. So, the npv of 10 annual rental payments of £150,000 assuming a borrowing rate of 5% is £1,158,260, which is very roughly 8 x £150,000 (£1,200,000).

But I see your problem with it now. Initially I said the asset was worth £1m, not £1.2m. I think the discrepancy occurs because £1m is the amount the company would pay for the lease asset if it paid in cash up-front assuming an interest rate of 5% and and a lease term of ten years.

The £1.2m includes the cost of financing the lease i.e the profit of the lessor, which I include on the balance sheet by using the eight times multiple.

But if the company takes out a £1m loan to fund the purchase of the lease asset, surely its liability is £1m. Which is, I think, what you are saying.

I'll leave it at that for now, while I go and panic!


It seems to me that there should be two rates at which the NPV of the payments should be calculated: (i) the cost equity rate for the use value, and (ii) the cost of financing rate for the interest portion.

If one calculates the NPV of the use-value payments (100,000) at 10%, the NPV of the interest portions (50,000) at 5%, and sum the two values, one gets 1.064 million which is 7.1 x rent.

For real estate (offices, shops, factories) anything between 7x and 8x is a reasonable rule of thumb and a pretty good approximation, too. For aircraft, 8x is better than 7x.

Michael's point -- that different cap rates will apply depending on the creditworthiness of the lessee, the length of the lease, the type of asset, the interest rate environment, and so on -- is a good one. But it's also worth bearing in mind that very few people have lost money on their investment because they capitalized at 7x/8x rather than an 5x/6x.

Losing money because one didn't capitalize at all, however, is a very frequent occurrence.

Hey red,

Principle payments and interest payment are both ingredients of debt, as such they need to be discounted by a 'cost of debt' rate.

Even if we'll think about using 'cost of equity', which is always higher than the cost of debt, for discounting anything, it shouldn't be for the principle payments, which suppose to be the safer part of the debt payments, in comparison to the interest payment, which reflects the profit of the creditor, lessor in our situation.

About the last point, it's true that using the 8x multiple will save you from getting burned, but it sure will prevent you from investing in some good investments, which seems to have unholy amount of debt, but in fact have an appropriate leverage.

Capitalizing op.leases the right way gives you an edge on other investors.


Hello Guys,

Thanks for the article and comments. They all help to bring some clarity to this important area of security analysis.

Can I ask you;

How does the capitalisation of op leases effect the restated cash flow statement. To calculate free-cash-flow in its simplest form you add back Dep & Amm and subtract maintenance capex.

If we break down the op lease payments into their constituent parts - dep & interest - should we add this additional depreciation back in the cash flow statement also??


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