Debt by any other name

Later this year – probably late September – when Card Factory (CARD) reports its first-half results, its borrowing ratios will be seen to have tripled and shares in the greetings-cards retailer, which was once a stock-market darling, will possibly continue on their descent when the grim truth is made plain. 

In round terms, Card Factory’s net debt, which stood at 63 per cent of shareholders’ funds at the end of 2018, may be restated to be more like 180 per cent. Alternatively – and through the lens of another measure much favoured in the City – the ratio of net debt to cash profits (so-called ‘ebitda’) could rise from about 1.6 times to 2.2 times. 

These changes should not really be labelled a deterioration in the group’s financial health since any weakness was already there. But it will be exposed even to novice investors because new rules that dictate the way companies must present their accounts are coming into force. As a result, costs and commitments that were relegated to the notes of companies’ accounts – an obscure area that even experienced investors often avoid – will be shown clearly on the face of the main statements of account – the income statement, the cash-flow statement and, most importantly, the balance sheet. This may be an eye-opener.

Specifically, what’s happening is that, for accounting periods starting from January 2019, companies must apply a new accounting standard, IFRS 16. This standard, which has been all of 12 years in the making, specifies how and where companies must show the effect of lease contracts in their accounts. As such, IFRS 16 is possibly the accounting industry’s final response to the 2008-09 financial crisis, which happened – so conventional wisdom now says – partly because too much of companies’ activities were accounted for ‘off balance sheet’ – in other words, they were hard to see, or even impossible. 

Even before the financial crisis, the scale of leases held off balance sheet was such that an accounting response was needed. In 2005, as the excesses that caused the financial crisis were building, the Securities and Exchange Commission, the US securities industry regulator, estimated that US-listed companies held about £1,000bn-worth of leases off their balance sheets. To put that figure into some kind of context, the US government’s borrowing requirement that year was about £125bn. 

In effect, that was £1,000bn-worth of obligations that were not recorded in company accounts, but they should have been because they brought with them commitments that were much the same as taking on debt to buy assets. Much the same applied to the accounts of UK companies. To understand why, let’s remind ourselves about the essentials of a lease. It is a commitment by a user – a lessee – to pay the owner of an asset – the lessor – for its use. The contract will be for a specified term at the end of which title to the asset may or may not pass to the lessee. 

As such, it is basically a rental agreement, but not all leases are equal. There are two sorts, though the difference between them is often fuzzy – operating leases, which tend to be shorter term and carry fewer residual rights, and finance leases, which are longer term and come with sufficient control of the assets in question as to be consistent with ownership. 

Since the mid 1980s, companies have accounted for finance leases much as they would for assets they have bought and funded with borrowings. The asset went on one side of the balance sheet and the present value of the future lease payments went on the liabilities side; in effect, that was the finance-lease debt. Then the use of the asset was written off as a charge to accounting profits – split between depreciation and notional finance costs – while the actual cash costs went through the cash-flow statement. With the advent of IFRS 16, pretty well all operating leases will be treated in much the same way. 

Table 1 shows how a balance sheet and income statement will look under the new accounting standard compared with how they looked when operating leases were treated in the old way. As a working example, we have used London-listed retailer Card Factory (CARD). That’s because retailers generally use a lot of operating leases, chiefly to rent shops, so their accounts will be markedly affected by the changes. More specifically, Card Factory’s business is heavy with operating leases – if it were ranked in Table 2, which shows the 20 constituents of the FTSE All-Share index that look like being affected most by IFRS 16, then it would come in at number 21. Thirdly, the simplicity of the group’s operations and the clarity of its accounts – aided by its explanation of how it will be affected by the new standard – makes it straightforward to estimate the effect on 2018’s numbers.

◼︎ The balance sheet

This is where the effects are likely to be greatest. The assets side of Card Factory’s balance sheet swells by £127m, which is the estimated value of the right to use the leased assets. On the other side, £145m of lease liabilities show up, which is the estimated present value of all the future rental payments that the group is committed to make on its leases (other, possibly, than very short-term or low-value leases). Because the lease liabilities are £18m more than the lease assets, there is a corresponding reduction in net assets, or equity. As to why the liabilities are more than the assets, this is due to what accountants call ‘timing differences’. 

Specifically, the value of leased assets will fall faster than the carrying amount of the liability because, in the early part of a lease, the effect of straight-line depreciation on the assets will be greater than the reduction in what is owed. So companies, such as Card Factory, with comparatively large amounts of newish leases on their books, are likely to bear a harder one-off hit in the shift to the new accounting treatment than those that are running down older lease commitments.

◼︎ The income statement 

Here, rental costs, which were deducted in order to calculate operating cash profits (so-called ‘ebitda’), will be split and charged to depreciation and interest. For Card Factory that is likely to raise ebitda by about £43m, or 48 per cent, from £89m to £132m. Timing differences will mean that slightly less – £41m – is charged to depreciation and interest and the split is likely to be about two-thirds to depreciation and one-third to interest. 

As a result, operating profits are 20 per cent higher – at £94.5m compared with £78.5m under the old standard – and pre-tax profits creep up by the £2m timing effect between rental costs under the old system and charges to depreciation and interest under the new one. Assuming the tax charge remains unchanged, then earnings per share nudge up, too. 

◼︎ Cash-flow statement 

There will be no change to a company’s net cash flow because the cash being transferred from lessee to lessor does not change under the new accounting rules (come to that, cash flow is unaffected by any accounting rules). That said, there will be changes to where the payments are allocated in the cash-flow statement. 

Rental payments on leases were previously a cash cost against operating cash flow. Henceforth, both the principal and the interest segments of lease costs will count as part of a company’s financing activities. As a result, operating cash flow will rise compared with the previous treatment and financing outflows will rise by the same amount, meaning that net cash flows will stay the same. 

Financial ratios

1. Debt to equity: Bringing onto the balance sheet assets that were previously held off-balance-sheet and allocating the present value of their future costs as debt will increase the notional amount of debt that a company carries. Simultaneously, adjustments to balance sheets just discussed will tend to trim the amount of equity employed. Thus the ratio of debt to equity is likely to rise. For companies that rely heavily on leased assets – such as retailers, but also transport and leisure-industry operators – the ratio may rise substantially. In Card Factory’s case, it is likely to triple from 63 per cent under the previous treatment to 188 per cent. 

2. Net debt to ebitda: This ratio is often used as an alternative to debt to equity. It may be more useful since it focuses on debt in relation to cash profits, which may assess a company’s ability to afford debt better than focusing on debt in relation to equity. For lease-heavy companies, this ratio is likely to rise under IFRS 16, although less than debt to equity since ebitda gets a boost. In Card Factory’s case, the debt-to-ebitda ratio rises from 1.6 times to approaching 2.2 times. 

3. Return on capital employed: As a measure of how well a company uses its capital, this ratio – shortened to RoCE – is vital; or it would be if it were possible to get a firm handle on how much capital most companies really employ. Conventionally, the ratio is calculated by expressing operating profits as a percentage of equity plus debt. That way, the extent to which a company is financed by debt or equity becomes irrelevant, making inter-company comparisons more useful. IFRS 16 has a big impact since it affects both operating profits and capital employed. It will boost operating profits because the interest part of lease costs is no longer charged to that line of the income statement. However, it will raise capital employed even more since all of the present value of future lease payments is capitalised on the balance sheet as quasi debt. The result – more profit but much more capital employed – results in a lower return on capital. In Card Factory’s case, RoCE for 2018 would fall from21.1 per cent under the old treatment to 18.9 per cent. 

4. Profit margin: This is a profitability measure that quantifies how much revenue is left over for profits; alternatively, how much revenue is eaten up by costs. Clearly, therefore, shifting a cost out of operating profits but keeping all else the same will boost profit margins. For Card Factory, the margin rises from18 per cent to almost 22 per cent. 

However, we might wonder to what extent the effect of applying IFRS 16 and noting the changed financial ratios tells investors something they don’t already know. It is a generic question that one can ask about most accounting treatments. But in the context of IFRS 16, the slightly contrived difference between finance leases (on balance sheet) and operating leases (off balance sheet) has been known for years. City analysts often make allowances for them. They adjust operating leases as if they were on-balance-sheet finance leases. The rule of thumb is to take the annual lease charge – shown in a note to the company’s accounts – and multiply that by eight. That gives a guesstimate of the present value of the future commitments, which, in effect, is the quasi debt. 

This does a job. Research by the International Accounting Standards Board (IASB), the accounting-standards setter, showed that for 1,022 companies, which had the lion’s share of off-balance-sheet leases among a global sample of 30,000 companies, the effect of applying the eight-times multiplier was to raise the ratio of long-term debt to equity from59 per cent as disclosed on the face of their accounts to 82 per cent. Actually, that exaggerated the risks because applying IFRS 16 to the same data only brought the ratio up to 74 per cent. 

Better to be safe than sorry. Yet the standards board worries that not enough investors – especially the unsophisticated ones – know about off-balance-sheet commitments at all, let alone quick-and-easy ways of bringing them into account. For example, it may be no coincidence that six well-known retailers that all went into liquidation or some form of administration during the 2000s all carried extremely high levels of off-balance-sheet leases. The question is whether the share prices of the six – and at various times some were stock market favourites, such as Circuit City of the US and Clinton Cards of the UK – would have climbed so high or been sustained for as long as they were if the risks inherent in their hidden commitments were fully known? 

Which is not to imply that any of the 20 companies shown in Table 2 face existential risks made plain by adopting IFRS 16. However, they are the 20 stocks in the FTSE All-Share index that arguably will be most affected by the new standard. They are ranked according to the lease-rental payments shown in their most recent accounts as a percentage of gross profits, which is used as a denominator because it should be more stable than a profit figure shown further down the income statement. What the table can’t do is discriminate between those companies whose portfolio of operating leases is comparatively short life and those whose commitments stretch far into the future, making the risks greater. Even so, the question is whether the share prices of these 20 will especially suffer as the risk implicit in having fat tranches of fixed lease costs is made clear by applying IFRS 16. 

Table 2: All-Share constituents  likely to be most affected by IFRS 16

Source: S&P Capital IQ; ranked by rentals/gross profit (see text); data for rentals and profit latest full year

Perhaps the stock market – as the collective wisdom of smart investors – has already discounted such risk. At least, the chart below indicates this may be so. This uses data from 22 stocks in the FTSE All-Share General Retailers sector, which represent companies that, as discussed earlier, are likely to employ a lot of operating leases. 

The chart asks: to what extent have changes in lease costs over the past three years influenced changes in share prices over the same period? In order to get a neat scattergram, a bit arithmetical tweaking was needed. 

First, so as to avoid inconvenient negative quantities, changes in lease costs – whose ability to ‘drive’ share prices is being tested – are shown as the ratio of rental costs to gross profits today compared with three years ago. For example, at WH Smith (SMWH) rentals were 37.8 per cent of gross profits three years ago and 36.5 per cent in the latest full year. So the ratio is 36.5 over 37.8 or 0.97. 

Second, in order to make the chart slope in a conventional way – ie, upwards from left to right – a further tweak was needed for share prices. By using the reciprocal of the ratio of the recent share price to the price three years ago, then higher values in the ‘y’ axis indicate worse share price performance. In WH Smith’s case, the recent price is higher – 2,116p compared with 1,546p three years ago – so the y value of its data point is 0.73. 

What’s interesting is that the chart does slope the ‘right’ way, linking a rising lease burden with a declining share price performance. The ‘rise over run’ – ie, the rate at which share prices respond to a given change in the lease burden – is almost 1.7. Reversing the reciprocal, means that – roughly speaking – for every percentage point that the lease burden rose over the past three years, on average share prices fell by 0.6 of a point. 

True, the qualifying factor is that the data points are strewn around so the line of best fit, from which the correlation is derived, is not much of a fit. That’s quantified by the ‘R squared’ value of 18.1, which basically says that the changing lease burden is responsible for 18 per cent of the share price changes. Yet, given that so many factors influence share prices, arguably that makes the lease effect quite significant. Most likely, we will know more about this after this year’s half-year results season – now getting into its swing – is over.