Menu
Home
Log in / Register
 
Home arrow Management arrow Strategic Management in the 21st Century. Corporate Strategy

Financial Flexibility and the Use of Other Financing Tools

The primary concern of financial managers when facing long-term financing decisions is how a financing decision today might impact future financing options. Sixty percent of respondents to a survey cited financial flexibility as the primary concern when making debt policy decisions.42 In particular, firms wanted to protect their credit rating and to preserve unused debt capacity to finance future investment opportunities. It is thus no surprise that financial managers consider off-balance sheet financing tools to meet their capital funding needs.

It is increasingly important for firms to remain flexible and to be able to adapt quickly to a changing environment. This means that the old, physical asset-intensive model may not work as well as it did in the past. Firms need to raise capital to purchase long-term physical assets that may be hard to sell in a timely manner. Raising capital is costly because debt financing increases the leverage ratio and equity financing can dilute shareholder value. However, some financing tools do not have to be classified as either debt or equity, and can thus be kept off a firm's balance sheet, thereby preserving the leverage ratio. Examples include operating leases and offbalance sheet entities for joint ventures, or research and development partnerships. Off-balance sheet financing has been attractive to many firms especially when the addition of a large amount of new financing would break their debt covenants. However, firms should be fully aware of both the positive and negative consequences of using these instruments. Although they can have a positive effect when used to improve leverage ratios or financial flexibility, they can also lead to legal consequences if used to artificially manipulate financial reports as was the case with Enron. Enron created several off-balance sheet entities known as SPEs, whose financial statements did not have to be consolidated with Enron's own statements. Unprofitable assets were then transferred to these entities to hide losses and make the company look financially healthy. After several accounting scandals in the early 2000s, both the Securities and Exchange Commission and the Financial Accounting Standards Board (FASB) increased disclosure requirements for off-balance sheet financing instruments. Two commonly used off-balance sheet instruments, leases and SPEs, will be explained in detail in the following sections.

Leases

A recent SEC study estimated that total (undiscounted) cash flows associated with off-balance sheet operating leases for active U.S. issuers may approach $1.25 trillion. This is 28 times more than the $45 billion of on-balance sheet capital leases.43 For companies in the S&P 500 stock index, off-balance sheet operating-lease commitments, as revealed in the footnotes to their financial statements, totaled $482 billion.44 From a financial viewpoint, the purpose of operating leases is to lower the conventional way of reporting debt. Under current U.S. accounting rules (GAAP), there are two types of leases, operating leases and capital leases. For a company to record a lease as a capital lease, the lease must meet one or more of the following four criteria:45

1. Transfer of ownership test: The lease transfers ownership of the property to the lessee by the end of the lease term.

2. Bargain-purchase option test: The lease contains a bargain purchase option. A bargain purchase option allows the lessee to purchase the leased property for a price that is significantly lower than the expected fair value of the property at the date the option becomes exercisable.

3. Economic life test: The lease term is equal to 75 percent or more of the estimated economic life of the leased property. However, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease. If the lease period equals or exceeds 75 percent of the asset's economic life, the lessor transfers most of the risks and rewards of ownership to the lessee. Capitalization is therefore appropriate.

4. Recovery of investment test: If the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, equals or exceeds 90 percent of the fair market value of the leased property, then a lessee should capitalize the leased asset. Because if the present value of the minimum lease payments is reasonably close to the market price of the asset, the lessee is effectively purchasing the asset.

If the lease qualifies as a capital lease, it is reported as a leased asset on the asset side of the balance sheet and a lease liability on the liability side, and the effect is the same as a purchase with borrowing. This will in turn affect the total amount of debt and the calculation of the leverage ratio, cost of debt, and cost of equity. As a result, firms with a high level of debt would prefer not to have a capital lease and may prefer to have an operating lease instead.

For an operating lease, the lessee records only periodic rental expenses but not any liabilities, thus helping to maintain a lower debt level. This makes the balance sheet and leverage ratios appear more favorable. Many airlines make extensive use of lease arrangements to acquire aircraft rather than purchasing them. According to 2009 company reports, between 16 percent (Southwest) and 42 percent (Republic) of the total fleet of airlines was leased using operating leases.4 6 This resulted in considerable offbalance sheet financing; thus decision makers including analysts, investors, and managers should adjust reported debt levels to account for the effects of the leases.

The following examples illustrate the financial impact of operating leases:47

• US Airways Group Inc., which filed for Chapter 11 bankruptcy protection, showed only $3.15 billion in long-term debt on its most recently audited balance sheet, for 2003, and didn't include the $7.39 billion in operating-lease commitments it had on its fleet of passenger jets.

• Drugstore chain Walgreen Co. shows no debt on its balance sheet, but it is responsible for $19.3 billion of operating-lease payments mainly on stores over the next 25 years.

• When UAL Corp., filed for Chapter 11 bankruptcy protection in December 2002, its audited balance sheet showed $25.2 billion of assets and $22.2 billion of liabilities. Not included: $24.5 billion in noncancellable operating-lease commitments, mostly for aircraft.

• Winn-Dixie Stores Inc.'s reported debt of about $300 million is just 30 percent of its shareholder equity. The footnotes show a far more leveraged company. Its off-balance sheet obligations at June 30, 2004 included about $4.1 billion of noncancellable commitments over several years to lease the buildings for its stores.

In addition to the effect on debt levels/financial reporting, other reasons exist for leasing. Graham, Lemmon, and Schallheim documented a negative relationship between a firm's use of operating leases and its marginal tax rates, and a positive relationship between debt levels and tax rates, supporting the hypothesis that firms with low tax rates lease more and have lower debt levels than firms with high tax rates.48 Krishnan and Moyer also found that leases become more attractive than secured debt as the potential for bankruptcy increases.49 Leases have lower associated bankruptcy costs than debt due to the superior claim of lessors over lenders. Since the lessee (borrower) must compensate the lessor (lender) for expected bankruptcy costs, a firm with significant bankruptcy potential will find leases to be available at a lower cost than borrowing.

One popular example of how a lease can be used for both tax incentives and financial-reporting purposes is a synthetic lease, a hybrid that takes advantage of the benefits of both capital and operating leases. Synthetic leases allow a lease to be treated as an operating lease for financial-reporting purposes to lower debt levels, while treating the lease as a loan arrangement for tax purposes by claiming ownership of the property. A firm can thus deduct payments for the property as interest payments on debt (rather than a rent expense) for tax reporting purposes. Specifically, investment bankers, in consultation with lawyers, structure the terms and covenants of the lease so that they can obtain favorable treatment for tax and financial-reporting purposes. At the end of the lease term, the lessee has the option of either renewing the lease, purchasing the property (for a predetermined price), or selling the property in the market. If it sells the property with a gain or loss, tax authorities usually consider the firm to be the virtual owner of the property as it assumed the risks and rewards from the property. As a result, the lessee can take depreciation and interest deductions available to owners and borrowers. However, for financial reporting purposes, it can design the lease terms so that it does not meet any of the four capitalization criteria for capital leases. The lease contract is thus accounted for as an operating lease, which in turn will not be recorded as a liability on the balance sheet.

 
Found a mistake? Please highlight the word and press Shift + Enter  
< Prev   CONTENTS   Next >
 
Subjects
Accounting
Business & Finance
Communication
Computer Science
Economics
Education
Engineering
Environment
Geography
Health
History
Language & Literature
Law
Management
Marketing
Mathematics
Political science
Philosophy
Psychology
Religion
Sociology
Travel