The inspiration for bashing out this WheelieBlog came whilst I was reading an excellent article written by Philip Ryland in the Investors Chronicle from 16th August 2019 (the one with the Chameleon/Lizard thing on the cover) entitled ‘Debt by any other Name’ and starting on page 33.
If you have access to the magazine in whichever format, I suggest you have a good read of it and perhaps it is best to read my (hopefully simple) blog first and I also suggest reading these excellent Guest Blogs by Justin Scarborough which are particularly useful if you need to brush up on basic understanding of Accounts (this is to Part 2 and there is a link inside it at the top to Part 1):
Why am I having to write this Blog?
I decided to create this because there was a change to the Accounting Rules which is designated as the ‘IFRS16’ Standard and this came into force for all Accounting Periods starting from January 2019 – so it has been in force for some time but I suspect the vast majority of Private Investors have not really paid much attention to it.
In essence, IFRS16 specifies where, and in what manner, Lease Contracts must be shown within a Company’s Accounts. Prior to this change, the details about Lease Contracts could be found in the ‘Notes’ to the Accounts which appear after the usual standard key tables such as the Profit and Loss Account, the Balance Sheet and the Cashflow Statement.
It is highly probably that most people barely even look at these tables and delving into the Notes section is probably something that is only done by a small group of Private Investors. To an extent I suspect this doesn’t cause too many problems and risks related to Accounts can be managed in other ways (such as use of Stoplosses and Diversification etc.), but if you do familiarise yourself with these detailed bits of the Accounts then it can often be very enlightening. After a while you start to figure out which bits are really important and useful and which bits are not so crucial.
Prior to the rules laid down under IFRS16, Lease Agreements were best described as “Off Balance Sheet” and that was unlikely to be a complimentary claim – it certainly has negative connotations. However, it must also be appreciated that in terms of the impact upon the Business with regards to things such as Cashflow etc. and the overall Financial Health, nothing has actually changed in ‘the Real World’ – it is in fact just a presentational matter but it does mean that the impact of Lease Contracts is now much more to the fore and highlighted.
Having said that, something that hit me whilst reading this article was that the impacts of the Lease Contracts are not all negative to the Balance Sheet and the Profit & Loss Account – in fact, there are some bits that get boosted by this change as I hope to show in due course. If anything, the most negative impacts probably hit particular types of Companies which have unusually high Lease Agreement levels, such as Retailers and Airlines etc.
What is a Lease Contract in Accounting terms?
I think this can be best explained by this direct quote from Philip Ryland’s article:
“…..let’s remind ourselves about the essentials of a lease. It is a commitment by a user – a lessee – to pay the owner of an asset – the lessor – for its use. The contract will be for a specified term at the end of which title to the asset may or may not pass to the lessee.”
The way I understand things, the words ‘Contract’ and ‘Agreement’ are pretty much interchangeable and ‘title’ means the ownership of the Asset in legal terms. To an extent, Lease Contracts are just a type of Rental Agreement. And just to put some stress on these vital definitions:
There are then 2 different types of Lease Agreements and it is vital to understand the distinction because they impact how IFRS16 gets applied to the Accounts:
Impact of the different Lease types on Company Accounts before and after IFRS16
Finances Leases have been treated much like an Asset that a Company has bought via Debt since the 1980s, and this has meant that the Value of the Asset sits on one side of the Balance Sheet and the total of the future Lease payments goes on the other side (by the word ‘side’ here I mean that one side is for Assets and one side is for Liabilities. Of course in practice you will usually see these laid out with the Assets first in the table and then the Liabilities underneath).
The use of the Asset is then in effect written-off as a Charge to the Accounting Profit in the Profit & Loss Account. This Charge has a Depreciation element and a Finance Cost element. The actual Cash Payments then get reflected in the Cashflow Statement.
The key change of IFRS16 is that Operating Leases (where the Lessee will not end up owning the Asset) will now be treated in the same way as Finance Leases.
How are each of the key Accounting Statements impacted by IFRS16?
On the Assets side of the Balance Sheet the stated Assets will rise to reflect the estimated value of the right to use the leased Assets.
On the Liabilities side there will be an increase for the estimated present value of the future Lease Rental payments.
Due to ‘timing differences’, the Lease Liabilities are likely to be higher than the Leased Assets, so the Net Assets are therefore lower (Net Assets is Total Assets minus Total Liabilities). This arises because the value of the Leased Assets falls faster than the outstanding Lease Liabilities due to the use of Straight-line Depreciation on the Leased Assets, and this will result in the value of the Leased Assets falling faster than the reduction in the Lease Liabilities which are owed.
This especially applies at the start of a Lease and it could be that Companies with older Lease Agreements suffer less of a hit to Net Assets as the rules of IFRS16 are first applied.
Profit & Loss Account
Previously on the P&L there were Rental Costs which were directly applied against Revenues to calculate Operating Cash Profits (in effect the legendary and much castigated EBITDA !!). With the advent of IFRS16 there will be 2 Charges to the P&L from a Lease Agreement which will be a Depreciation Charge and a Finance Charge. Again, there is a timing effect here because the Depreciation and Finance combined are likely to be lower than the previous straight out Rental Payments.
This change is likely to increase EBITDA compared to the previous situation. This should boost Net Profits also and increase Earnings Per Share but that assumes there is no change to the Tax Charge which might occur if Profit rises sufficiently to cross a Tax threshold.
There is no change to the Company’s Cash Flow because payments from the Lessee to the Lessor are unaffected – this is purely a change in the Accounting treatment not in terms of the real-world cash movements. There will however be changes to where the Payments are allocated on the Cashflow Statement.
Previously the Rental Payments were entered against Operating Cash Flow but now both Rental and Depreciation elements are entered as Financing Activities. This means Operating Cash Flow will rise but Financing Outflows will also rise so the net effect is no change in the real Cash Flows.
How are commonly used Investment Ratios impacted by IFRS16?
Debt to Equity
In effect IFRS16 brings Assets that were previously ‘off balance sheet’ back onto the Balance Sheet and also brings the Present Value of the future Payments onto the Balance Sheet as more Debt (liabilities). At the same time, the changes to the Balance Sheet that I highlighted previously also mean that the Net Assets (Equity) reduces.
As a result, we will have higher Debt and lower Equity so the Debt to Equity ratio is likely to increase and this will be particularly bad for Companies which use a lot of Leased Assets such as in Retail, Transport, etc.
Net Debt to EBITDA
In effect this ratio compares Net Debt to Cash Profits (it is arguably more useful than the above ratio because it looks more at the Cash a Company generates which has more impact on the Company’s ability to afford the Debt). In this case under IFRS16 the Net Debt will be higher but the EBITDA will improve, so overall we would expect the Net Debt to EBITDA to increase but not as much as the Debt to Equity ratio. That would especially be the case for Companies with high Lease levels.
ROCE (Return on Capital Employed)
In essence this ratio indicates how efficiently a Company uses its Capital – the higher the better. Normally the ROCE is calculated by expressing Operating Profits as a percentage of Debt plus Equity.
IFRS16 affects both Operating Profits and the Capital Employed so it has quite an impact. Operating Profits get a boost and Debt increases a lot because the future Lease Payments are capitalised on the Balance Sheet as Debt in effect. This means a lower ROCE after IFRS16 because Operating Profit goes up a bit but the Capital Employed rises a lot due to the Debt.
Because Operating Profits improve as some Costs are in effect timed differently, the Profit Margin will improve as it is expressed as a proportion of Revenue which stays the same.
OK, that’s it. Hopefully if you take your time and dig through this slowly then it should make some sense. Something that stands out to me is that the adoption of IFRS16 is not entirely a negative and there is a bit more to it than simply saying that the Debt of a Company will go up. If you have access to a copy of that Investors Chronicle article that I mentioned at the start of this blog, then it might be a good idea to read through that as well.
Many thanks to Philip Ryland for writing this superb article and I especially appreciate that it has helped me to understand the impacts of IFRS16 hugely and it is yet another example of the value within Investors Chronicle magazine and why it is well worth the cover price.
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