Question

Describe how a capital lease could negatively impact the lessee’s financial ratios. If you were the lessee, which type of lease would you have preferred and why.

Answer 1

A lease is a contractual arrangement calling for the lessee (user) to pay the lessor (owner) for use of an asset. The leases are of 2 types. Capital lease and operational lease.

To be classified as a capital lease under U.S. GAAP, any one of four conditions must be met:

• A transfer of ownership of the asset at the end of the term
• An option to purchase the asset at a discounted price at the end of the term
• The term of the lease is greater than or equal to 75% of the useful life of the asset
• The present value of the lease payments is greater than or equal to 90% of the asset’s fair market value

The amount of capital lease is reflected as fixed asset and lease obligation in the liability side of Balance sheet. Lessee makes single consolidated lease payment consisting of interest and principle component. Lessee can claim interest and depreciation. Whereas in operating lease, no adjustments were required in balance sheet. Annual lease payments are debited to income statement.

When comparing with operating lease capital lease will result in reduction of net income since depreciation on leased asset and interest are charged to income statement. So it will have negative impact on various financial ratios such as net profit ratio, Return on equity,interest coverage ratio, return on asset etc..

Both capital and finance leases are commonly used bycompanies. Each type of lease have its own advantages. Depending on companies requirement and tax situation they may opt for one.If I am the lessee i will choose capital lease since it has following benefits

1. Depreciation and interest expenses will reduce the taxable income.
2. Lessee has about base option at the end of the lease term.