If a company reports under IFS and has a material lease portfolio, then it's really important that the lease items are modeled correctly.

Otherwise, it could distort the model outputs.

When we model with leases, we need to have a really good understanding of the linkages between the income statement, the balance sheet, and the cash flow statement.

So let's take a look at those.

The easiest way to understand them is through base analysis as shown here, and we need to note that here.

We are gonna run base analysis separately for both the lease assets.

That's the right of use assets and the lease liability.

Also, these two base calculations are linked as we'll. Soon see the base analysis for the right of use asset links the beginning and ending balance on the right of use asset in the balance sheet by adding lease CapEx.

That is the present value of new leases signed each year.

The next step is to subtract the depreciation on the lease portfolio in the year.

So this base calculation looks almost identical to base calculation for property, plant, and equipment where we add CapEx and subtract depreciation each year.

The base analysis for the lease liability links the beginning and ending balance on the lease liability in the balance sheet by again adding lease CapEx, and that's the same lease CapEx, which was included in the base calculation for the right of use asset.

Remember that this is the present value of new leases signed in the year.

However, in the context of the lease liability, we can think of this as equivalent to new loans.

That's new liabilities taken out in the year.

The next step is to add the lease interest.

This is the interest which is accrued on the lease liability because the discount on that lease liability unwinds each year.

The final step is to subtract the lease payments which are made in each year because that will lower the amount owing on the lease liability.

So this lease liability calculation includes additions for new loans or liabilities.

It also adds interest and subtracts the liability repayments.

Does that sound familiar to you? Effectively, this is almost identical to the base analysis that we would run for an amortizing bank loan.

So how can we forecast the items in our base analysis? Well, on the asset side, the best thing to do is to assume that we're actually forecasting physical property, plant and equipment.

The lease CapEx is forecast as a percentage of revenue in exactly the same way as we would forecast physical CapEx as a percentage of revenue.

This is because we would ordinarily need To assume that a company will need to grow its lease portfolio in order to grow its revenues.

And how can we create this assumption? Well, we can look back in time through the historical footnotes to see lease additions as a percentage of revenues historically and use that to make our forecasts.

We then forecast the depreciation on the lease portfolio as a percentage of the opening asset balance in the same way as we would forecast depreciation on property, plant, and equipment On the liability side, the lease CapEx is the same lease CapEx that we used for the right of use asset.

Whilst the lease interest is forecast using an interest rate assumption multiplied by the opening balance on the lease liability, where can we make the assumption about the interest rate on the lease portfolio? Well, the footnotes to the financial statements usually give a disclosure on the effective interest rate in the lease portfolio, and we can use that as our starting point.

The lease payments are then forecast just as the sum of the depreciation and the interest on the lease.

The final step is to link these items into our model.

The depreciation and interest from the calculations are included in our income statement in our model.

Whilst the ending balance from the base calculations are included in the balance sheet for the right of use asset and the lease liability, the cash flow statement is a little bit trickier.

First, let's look at the operating cash flows.

Remember that we add back depreciation when calculating operating cash flows.

We'll continue to do this for depreciation on lease assets.

Because this is a non-cash expense, we then need to capture the lease payments from our base analysis because this is an actual cash flow and it needs to be included as a financing cash outflow.

In our cash flow statement, it's effectively like a loan repayment.

One final adjustment is in relation to the interest expense from the lease liability because interest is typically included as an operating cashflow rather than a financing cashflow.

In the cashflow statement, the lease payment, which is included in the financing section, is not the whole lease payment, it is the lease payment net of the interest expense.

This is sometimes referred to by companies as payment of their lease principle.