Return on Capital and Capitalising Leases

Strategy

AHG argues that the industry, investment community and banks do not take operating leases into account as part of the capital calculation.

However, in economic terms, operating leases are like any other form of debt. Hence they should be treated in the same way.  While the accounting treatment of capital leases and operating leases currently differs, the economics of the two types of leases is similar.  The company is committed to meet the repayments for the term of the lease. (Note: as you will be aware, there is an accounting standards draft that proposes operating leases be capitalised on a company’s balance sheet).

Excluding operating leases as a form of debt can give a misleading gearing ratio, eg ABC Learning’s disclosed gearing in 2007 was 1.14:1.  Incorporating operating leases, it was 2.03:1.

Just as say the market value of capital leases can be calculated, so should the market value of operating leases, being the present value of the committed future lease payments discounted at a rate that reflects the risk to AHG.

Turning to project evaluation, the first decision in capital investment is whether the project meets the company’s hurdle rates.  How the project is financed is a secondary decision.  Therefore a means is required to evaluate the project on its merits independent of whether leases are used or not.  Rather than using a two-step approach, the AHG method appears to assume the financing decision is a given (ie, operating lease) and then to exclude the present value of the long-term debt commitment into which the company is entering.  

Excluding this debt commitment from project evaluation eliminates the ability to compare the performance of historical investments that have been financed in different ways, for example comparing a project where the assets have been purchased outright against those that are debt funded, or funded using a capital lease, against those that utilise operating lease funding.  This then prevents you considering the real opportunity cost of alternative investments; and opportunity cost consideration is at the core of SVA.

Other concerns raised by AHG relate to using a different measure internally to those that are reported to the market.  My understanding is that Wesfarmers do just that: they have their planning metrics and they have their external reporting metrics.

In the case of WES, my understanding is that operating leases such as for property are all capitalised and this is taken into account in determining Return of Capital.  Yet low margin retail operations such as Bunnings are still able to deliver ~25% ROC last year.

If, in AHG’s case, new car inventory and operating leases are eliminated, you are effectively left with a business that consumes little or no capital.  Looking at the balance sheet and future lease commitments, this is clearly not the case.  Yet management want to use a metric such as Return on Sales that is applicable to a no/low capital enterprise.

There is then somewhat of a disconnect if we use SVA at the corporate centre without devolving responsibility for capital efficiency beyond head office.  The idea of SVA is to turn managers into owners in the way they choose to deploy capital.

Finally, in calculating Shareholder Value Added, it is normal to capitalise significant lease commitments.

For more information, please feel free to email me at john.barrington@barrington.com.au.

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