operating lease v. capital lease finance, 2011, capital, someone

simeezee

mind is fried, can someone help throw some water on it?

- how does a finance lease v. a operating lease cause a higher debt/equity ratio?



Edited 1 time(s). Last edit at Friday, May 13, 2011 at 07:44PM by msr.

bapswarrior

Operating lease is just like a Company renting a piece of machinery (no transfer of ownership). So neither debt or equity is changed.

Finance lease is basically the Company taking out a loan to buy a piece of machinery. So assets would increase by the same amount as debt, so equity would remain unchanged. The Company takes on new debt, so debt (numerator) goes up but equity (denominator) is unchanged.

Say Company X has Debt of $500 and Equity of $100 (D/E = 5). They take out a finance lease to buy a $300 machine. Assets would increase by $300 (the machine they now own) but debt also increases $300 (the loan to buy the machine). Since assets & liab increase the same amount, equity is unchanged.

The new D/E = $800 ($500+300) /$100 (unchanged) = 8

Make sense?



Edited 1 time(s). Last edit at Friday, May 13, 2011 at 07:54PM by thisisbrianly.

Penny-wenny

You bridged the gap with the fact that finance leases were debt funded, not by equity.
Thanks thisisbrianly!
M