The poor airlines—I suppose it’s just not allowed to let them revel in their success. Everything seemed to be going their way. Reduced competition and low oil prices had combined to drive profits and stock prices to all time highs. But lest they get too comfortable, the US accounting standards board, FASB, decided it was time to knock them back down a few pegs. See, last week FASB finalized a change in how operating leases would be accounted for under US GAAP. Currently, airlines use operating leases as one way to finance the acquisition of aircraft, and under the current standard, operating leases are not recorded as liabilities on a company’s balance sheet. Instead, their disclosure is relegated to the footnotes where those untrained may not be predisposed to look. Under the new standard, any company incurring an operating lease obligation will be required to report that on its balance sheet.
This will not be a big news event for trained accountants or financial analysts. But for those investing for their own account, it may highlight a potential risk in the current lease accounting reporting standard, and serves as a reminder not to ignore the footnotes.
What are the implications? Say I was analysing the big three airlines in the US: United, American and Delta. If I wanted to assess their level of financial stability, I would start by calculating their indebtedness and their ability to repay such indebtedness. The leverage ratio of “Net Debt / EBITDA” is a common measure of liquidity used by banks and investors alike. Essentially, it estimates the number of years it will take for the company to pay off its obligations. Typically a leverage ratio higher than 3x is seen as riskier than average, though any assessment of financial stability has to include an evaluation of the strength and resilience of said business.
Looking at the airlines, under the current reporting standards Net Debt/EBITDA stood at less than 1x for both Delta and United, and at 1.6x for American. If I include their operating leases (and make an adjustment to EBITDA to exclude rent expense, an adjustment that bankers typically make when lending to companies with high levels of operating leases), then those ratios climb to well above 2x for American and United (almost 3x), and just under 2x for Delta. Any investor sitting at home contemplating buying the stock of one of these companies needs to appreciate the increased risk that represents.
But the airline industry is not the only industry affected. Indeed, the most common use of operating leases is for real estate in the retail industry. Looking at a broad range of retailers in the US, the new accounting directive will have a massive impact on the appearance of many financial statements. On the surface, mall retailers the Gap, Abercrombie & Fitch, American Eagle Outfitters, Urban Outfitters, The Children’s Place and Finish Line (shoe retailer) all appear to be financially rock solid with no net debt. But include operating leases and most of these companies’ financial leverage jumps to over 2x! Budget priced retailer Kohl’s has debt on its balance sheet, but its leverage ratio balloons from 1.3x to 3.2x—that’s getting into risky territory.
I don’t imagine that the new disclosure rules will dramatically tip the balance of any single company’s credit worthiness, but more transparency is always better. If you are thinking of investing in a retailer, or airline, or other company that leases real estate or large volumes of equipment, be aware of how lease accounting works and protect yourself from getting blindsided.
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