If a company reports under US GAAP and has a material operating lease portfolio, then it's important that the lease items are modeled correctly.
Otherwise, it could distort the model's 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 starting point for operating leases is typically the lease expense in the income statement.
For simplicity, we usually assume that this reflects the annual rental payments.
However, we also need to be aware that these leases are capitalized on the balance sheet showing a lease liability, which reflects the present value of the future lease payments.
At the same time, whenever a lease liability is recognized in the balance sheet.
This also creates an identical right of use asset in the balance sheet.
This just means that the company has the right to use the lease asset during the lease term.
When a lease payment is made.
This lowers the lease liability, but it also lowers the right of use asset by the same amount.
So our calculations assume that the change in the lease liability each year is also the change in the right of use asset that year.
So how can we forecast these calculations? Well, the lease expense is usually forecast using either a growth rate assumption or as a percentage of revenues.
This depends on whether we view the company's lease expense as more of a fixed cost in the short term, in which case we would use a growth rate or a variable cost in the short term, in which case we would link the expense to revenues.
The lease liability is then usually forecast using either a multiple or a capitalization rate.
If we're using a multiple, we multiply this by the lease expense to give the lease liability.
The multiple therefore assumes that the present value of the future lease rentals are equivalent to a fixed multiple of the annual lease expense.
The multiple therefore depends on both the average lease term in the portfolio and the company's cost of borrowing, and the lease liability is higher if the company has a longer lease portfolio or a low cost of borrowing.
The multiple used in our calculations can be estimated by looking at the historic multiple for the company and then considering whether there are any expected major changes to the average lease term or the company's cost of borrowing.
A capitalization rate is just the inverse of a multiple.
So if we're using a capitalization rate, we instead divide the lease expense by the capitalization rate.
When calculating the lease liability, we then need to link these calculations to our model.
The lease expense is included within the income statement.
We then include the lease liability and right of use asset in the balance sheet.
There is no cashflow statement adjustment needed.
Since rental payments are included in operating cash flows under US gaap.
Remember that these rental payments are already deducted from net income as they're assumed to be the same as the lease expense.
One final important question to answer is why we bother to forecast leases in the balance sheet.
If they have no impact on profits or cash flows and the change in the assets and liabilities net out each year, surely we could just hold them constant in our forecasts and make the modeling easier.
Although some analysts do choose to do this, it creates a major issue with the sense checks in our model.
If we don't properly forecast the lease assets and lease liabilities in line with our earnings forecasts, then our forecasts of return on invested capital won't make any sense.
In all likelihood, it will result in forecasts, which suggests that the company is becoming more capital efficient, particularly when compared with a company which purchases its property, plant, and equipment.
By modeling the lease assets and liabilities, we can sense check the return on invested capital trend in our forecasts and compare the forecast return on invested capital to that of peer companies.
