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Are you adjusting operating income for operating leases in your investment valuation? If not, you are understating the EBIT in your DCF or relative valuation analysis. In this video, I cover the difference between finance and operating leases. I also show how to estimate operating lease interest and make adjustments in investment valuations.

Finance Lease vs Operating Lease: Definition

First, what is the difference between an operating and finance lease? Under the US generally accepted accounting principles (US GAAP), a finance lease is a contractual arrangement satisfying one of the following:

1. Transfer of title: the ownership of the asset transfers from the lessor to the lessee by the end of the lease term.
2. Bargain purchase option: there is a bargain purchase option that the lessee is reasonably certain to exercise.
3. Lease term: the lease term covers the majority of the remaining useful life of the asset.
4. Present value: the sum of the present value of lease payments and residual value is greater the fair market value of the asset.
5. Alternative use test: the asset is specialized enough that it does not have any use except for the lessee.

There used to be bright lines test numbers, but ASC 842 removed them. In essence, the asset will have no value at the end of the finance lease term without substantial revamp by the owner. Any other lease that is not satisfying any of these five tests is an operating lease.

Finance Lease vs Operating Lease: Financials

When it comes to investment valuation, here is what you need to know about lease accounting. Any lease is a form of debt. When you sign a rent agreement, you are under the obligation to make payments for a certain period of time.

Moreover, you must record a lease asset and a liability on your balance sheet. The lease asset is also called right-of-use asset (ROU). This is so because you are getting an asset that you can use for a specified period of time.

Financial Statements Presentation

Here is a table that summarizes how the US GAAP treats finance leases vs. operating leases.

As you can see, the difference that is important for investment valuation will be on the income statement. A finance lease accounting has two main components. These are the interest expense and depreciation expense. Conversely, accounting for operating leases involves only a rental expense that is subtracted straight out of the revenues. The rental expense is typically buried somewhere in the SG&A line.

International financial reporting standards (IFRS) treat all leases as finance type. If we think about it, it makes sense. Any lease is a form of financial obligation, which has an embedded interest expense in it.

US GAAP did not go far enough and decided to preserve its legacy definition of operating leases. The operating lease liability and asset are correctly recognized on the balance sheet as it should have been long time ago. This is good news since you don’t need to capitalize operating leases any more for your valuation. But, the interest expense is swept under the rug and gets buried in operating expenses.

Add Back Operating Lease Interest

Why is this important? Because, when valuing a company, it is crucial to separate operating items from financing ones. Doing so allows you to laser-focus on and value the company’s operating assets.

Unfortunately, the US GAAP wants companies to subtract the entire rental expense from operating leases in EBIT calculations. But, there is an interest expense component embedded in the rental expense. This effectively understates operating income. Thus, we should estimate and add back the operating lease interest.  

Authoritative books, such as “Valuation” by McKinsey & Company, advocate making this adjustment. If you are new to investment valuation, I highly recommend this valuation book. While there are many books out there, this is by far the most authoritative and comprehensive book on valuation I have ever seen.

This way, you will treat all leases as debt in a consistent manner. Moreover, you can make comparisons of valuation metrics across American and international companies.

How to Make Operating Lease Interest Adjustment?

So, let’s take a look at an example. Consider Kroger. In 2022, Kroger reported a rent expense of $950 million from its operating leases.

All of it was subtracted from the gross profit to arrive to the operating income. Our task is to estimate the interest expense component of operating leases. For that, we need the interest rate Kroger used to discount the operating lease payment.

Looking at Kroger’s 10-K, we find this excerpt.

It refers to the discount rate, which is 4.2% in 2022. Further, we can take an average of discount rate for the past two years, which is 4.15%. This may make sense since Kroger likely makes lease payments on a monthly basis.

Next, go to the balance sheet and find operating lease liability.

Then, compute the average balance for 2022. This will be the average of $7,034 and $7,076 million, which is $7,055 million. Then, multiply the discount rate of 4.15% by $7,055 million. This produces the interest expense of $293 million.

After that, add $293 million back to the reported EBIT of $4,126 million. $293 million represents about 7% of Kroger’s report EBIT, which is material for the valuation purposes. In some cases, a company may have an even higher reliance on operating leases. This can make the lease interest adjustment even much bigger.

Concluding Remarks

If you are comparing American and foreign companies, you need to make an adjustment for the operating lease interest. The US GAAP and IFRS treat leases differently and this matters for investment valuations.