The IFRS 16 lease accounting standard impacts financial statements. This is how the standard affects financial ratios that investors typically use to measure company performance.
With the enforcement of IFRS 16, operating leases as well as finance leases are now recognized on the balance, leading to a rise in both reported assets and liabilities due to the addition of the Right of Use (RoU) asset and corresponding lease liability. On the income statement, IFRS 16 eliminates the lease expense for operating leases, and is replaced by components of depreciation based on RoU and interest expense based on the lease liability.
This is how the IFRS 16 lease accounting standard impacts financial statements
- The lease liability that is capitalized represents the present value of future lease payments.
- The Right of Use (RoU) asset, recorded on the asset side of the balance sheet, comprises this present value plus any upfront direct costs associated with the lease.
- In the periods that follow, the liability incurs interest and decreases as lease payments are made.
- During the same periods, the RoU asset is depreciated over the expected economic lifetime of the underlying asset, usually equal to the lease term in the contract including any extension options in the lease that are expected to be exercised.
- On the income statement, what was previously recognized as a lease expense for operating leases is now replaced by components of depreciation based on RoU and interest expense based on the lease liability.
- As a result, both assets and liabilities are expected to increase with the inclusion of additional lease contracts.
- Compared to the approach under IAS 17, expenses are now higher in the early stages of the lease and diminish over its term.
- However, in the income statement, the sum of all costs for all periods in the entire lease term remains the same.
12 financial ratios
How will important financial ratios be impacted by IFRS 16 – key performance indicators typically studied by investors and analysts? Below, we go in to further detail on 12 different financial ratios:
- EBITDA
- Price/Earnings (PE)
- Operating Profit
- Net Income
- Return on Equity (ROE)
- Price-to-Book (P/B) ratio
- Enterprise Value-to-EBITDA
- Debt-to-Assets ratio
- Debt-to-Equity ratio
- Return on Assets (ROA)
- Interest coverage ratio
- Lease Intensity
EBITDA
IFRS 16 results in an increase in assets, liabilities, and net debt. Moreover, other operating expenses will be reduced as lease expenses are reversed from the profit and loss statement, depreciation expenses will be increased due to capitalized right-of-use assets, and interest expenses will be increased due to higher liabilities in the balance sheet.
As the expenses from IFRS 16 mostly relates to interest and depreciation, the standard will have a positive effect on the EBITDA compared to non-IFRS accounting. It's important to note that while EBITDA increases, it doesn't imply an improvement in operating cash flows, but merely an accounting change. Therefore, analysts most often adjust their approach to calculating EV/EBITDA.
Price/Earnings (PE)
The price/earnings (P/E) ratio is a valuation measure comparing the current share price of a company to its per-share earnings. IFRS 16 influences the P/E ratio primarily through its impact on reported earnings.
Earnings (or net income) may initially decrease because front-loaded interest expense tends to be higher in the early stages of a lease compared to the straight-line lease expense recognized under the previous standard (IAS 17). However, over the life of the lease, the total expense recognized will be the same.
So, there will most likely be short-term increase in P/E ratio – given that the share price remains the same. Also, the long-term effect on P/E ratio is neutral.
Operating Profit
Operating profit is likely to increase in the earlier years of a lease because the lease expense is replaced by depreciation and interest expense, which are typically lower in the earlier years of a lease.
Net Income
In the short term, net income may decrease because the sum of the new depreciation charge and interest expense is typically higher than the straight-line lease expense that would have been recognized under the previous standard, IAS 17.
Return on Equity (ROE)
The Return on Equity (ROE) measures a company's ability to generate profits from its shareholders' equity. The overall impact of IFRS 16 on ROE is a potential decrease, especially in the initial years of the lease. This decrease is due to the combined effect of lower net income and the relatively stable shareholders' equity, as equity does not increase due to the recognition of right-of-use assets and corresponding lease liabilities.
Over the life of the lease, the total impact on net income is neutral, but the timing of expenses affects the ROE differently across the lease term. In the later years of a lease, when the interest expense component is lower, the impact on ROE may be less negative or even neutral compared to the earlier years.
Price-to-Book (P/B) ratio
The price-to-book (P/B) ratio compares a company's market value (share price) to its book value. The P/B ratio is calculated as the market value of a company's shares divided by its book value (total assets minus total liabilities).
The recognition of right-of-use (RoU) assets increases the total assets on the balance sheet, which is part of the book value. Correspondingly, the recognition of lease liabilities increases the total liabilities.
If the increase in assets (due to the RoU assets) is greater than the increase in liabilities (lease liabilities), there will be an increase in book value, which might reduce the P/B ratio, assuming the market value of the shares remains constant. And vice versa.
Enterprise Value-to-EBITDA
EV/EBITDA is a valuation metric used to compare the value of a company, including debt and equity, to its cash earnings excluding non-cash expenses. Here's how IFRS 16 can affect this ratio:
The enterprise value (EV) may increase because lease liabilities are now recognized on the balance sheet and are now recognized on the balance sheet as interest-bearing debt. Since EV includes the market value of debt, the addition of lease liabilities will increase the EV.
As mentioned above, EBITDA increases because lease expenses, previously recorded entirely as operating expenses, are now replaced by components of depreciation based on RoU and interest expense based on the lease liability. Depreciation and interest are below the EBITDA line, which means that what was once an operating expense is now excluded from the EBITDA calculation, leading to higher EBITDA figures.
The impact on the EV/EBITDA ratio could go either way, depending on which of the above effects is greater.
Debt-to-Assets ratio
IFRS 16 impacts debt as well as assets. The right-of-use (RoU) asset increases the total assets on the balance sheet – the denominator. Likewise for the numerator: The lease liability, representing the present value of future lease payments, increases total debt.
Due to the front-loading of expenses and the way the lease liability is measured, the increase in liabilities (lease liability) may be larger than the increase in assets (RoU asset). If so, the debt-to-assets ratio will increase.
The adoption of IFRS 16 results in a more leveraged balance sheet than under the previous leasing standard, IAS 17. This change could potentially affect stakeholders' perceptions and covenants based on this ratio.
Debt-to-Equity (D/E) ratio
As mentioned above, the lease liability, representing the present value of future lease payments, increases total debt – the numerator. This is because companies must record all lease obligations on the balance sheet as liabilities.
IFRS 16 should not have a significant direct impact on retained earnings or other equity accounts. Over time, however, the new standard can affect retained earnings as the depreciation and interest expense profiles may differ from the straight-line lease expense previously recognized under IAS 17.
As a result, the debt-to-equity ratio will generally increase because the total liabilities of the company increase without a proportional increase in equity.
Return on Assets (ROA)
The Return on Assets (ROA) ratio measures how efficiently a company uses its assets to generate profit, calculated as net income divided by total assets. IFRS 16 has a notable impact on this ratio.
First, there is an increase in assets, due to the recognition of right-of-use (RoU) assets for leases. Then, there is a change in net income that varies over time. Initially, there might be a decrease in net income due to the front-loaded interest expense. Over the life of the lease, the total expenses recognized will be the same as before, but the timing of expense recognition impacts the net income differently from year to year.
Interest coverage ratio
The interest coverage ratio is a measure of a company's ability to pay interest on its outstanding debt, calculated by dividing EBITDA by interest expenses. Both the numerator and the denominator increase.
As already mentioned above, IFRS 16 causes EBITDA to increase. Likewise, since the interest component of the lease liability is treated as a finance cost, the reported interest expenses increases.
Given these changes, the impact on the interest coverage ratio is mixed. The net effect on the interest coverage ratio will depend on the proportion of the changes in EBITDA relative to the changes in interest expenses.
Lease Intensity
The lease intensity ratio is a measure of the extent to which a company uses leasing as a financing strategy relative to its total debt.
With IFRS 16, lease liabilities for all (operational) leases are now recognized, which increases the numerator of the ratio. The total debt of the company will also increase because the recognized lease liabilities are included in the company's debt calculations.
The lease intensity ratio will increase. The extent of the increase will depend on the relative size of the company's operating lease commitments compared to its other debt. If leases are a significant component of a company's financing strategy, the lease intensity ratio could increase substantially under IFRS 16.
