FOOL ON THE HILL
An Investment Opinion
Debt not only tells an investor where he stands in terms of claims against a company's assets, but helps determine risk. The more risk, the greater reward shareholders should expect. As a result, it's important to get a full understanding of a firm's current and long-term liabilities.
Most of this is covered on the balance sheet, that lovely snapshot of what a company owns and owes. But investors have to dig deeper since many companies have obligations just as real as debt, yet don't appear on the balance sheet. That's why it's called off-balance sheet financing.
This kind of financing takes many forms, including leases, the sale of receivables with recourse, limited partnerships, joint ventures, etc. But since there isn't space to go through the whole list in one story, I'll focus on leases. (A big, heavy, thorough, and pricey source of information on this topic is The Analysis and Use of Financial Statements, which was very helpful in writing this article.)
There are two basic kinds of leases: operating and capital. Under an operating lease, a company is essentially renting an asset for a portion of its life. Since there is no sale of the asset, the company doesn't have to load up its balance sheet with heavy debt. Rather, it just makes monthly rental payments recorded as expenses. Companies like structuring leases this way as they obtain use of the asset without handicapping the balance sheet, leverage ratios, or the cash flow statement.
It's a different story with capital leases. Under this type of agreement, which is treated as a sale, ownership rights are transferred to the lessee. As a result, the risks of ownership are apparent on the balance sheet.
Let's take a look at retailer Gap Inc. (NYSE: GPS) and holding company UAL (NYSE: UAL), which owns United Airlines, one of the world's biggest air carriers. For both companies, it's worth going beyond the balance sheet to understand how they account for leases.
Gap ended last year with $1.2 billion of long-term liabilities on its balance sheet. That's great for a market-leading company that generated $1.4 billion in operating cash flow in 1999. With $2.2 billion in total shareholders' equity, Gap is traveling light.
Yet in the notes to its financial statements -- which is where you find details about leases as well as other crucial financial tidbits -- Gap discloses that it has $4.6 billion in noncancelable minimum lease commitments, all of which are operating leases. Whether a company reports its leases as operating or capital, noncancelable commitments represent debt, plain and simple. If I sign an agreement with a lessor obligating me for x payments over y years, you can bet my creditors are going to count that lease as long-term debt. Fools should do the same.
Now, it's important to note that Gap isn't doing anything wrong reporting its lease commitments this way. There are strict criteria that define capital leases, according to Generally Accepted Accounting Principles (GAAP), and I'm sure Gap is well within the guidelines. Neither am I building a case against the company. Gap isn't highly leveraged or dealing with liquidity problems. The point here is that investors have to be aware that the lease commitments exist, especially when comparing ratios of industry competitors or looking at companies that operate close to the margin. (For a much closer look at Gap's operations, investors should check out analyst Bob Fredeen's company report offered by Motley Fool Research.)
Next, look at UAL's balance sheet, which itemizes $2.3 billion in long-term obligations for capital leases on its latest 10-K. Problem is, investors have to check the notes to see that UAL's capital leases represent just a small percentage of its total lease obligations.
See, as of December 31, UAL leased 317 aircraft and only 76 were structured as capital leases. UAL has $14.4 billion in noncancelable operating leases for aircraft, and another $7.7 billion in operating leases for property other than aircraft. Not all of this gets added back to the balance sheet since the figure has to be adjusted using a present value calculation, but it's safe to say the $9.4 billion in long term liabilities is significantly higher, perhaps by as much as $10 billion.
Again, the company isn't doing anything wrong here. It's following GAAP procedures, and many companies in the airline industry structure leases this way. As investors, it's up to us to be aware of the practice and to account for it in our analysis.
It's also worth knowing that accounting differences between types of leases affect the cash flow statement as well as the balance sheet. Payments for operating leases are pretty straightforward, appearing as cash outflows from operations. Capital lease payments, however, are divided between operating activities and financing activities. As a result, companies that use capital leases will often report higher cash from operations than peers that use operating leases.
It's kind of nasty stuff to wade through, to be sure. The simple thing to remember is the difference between capital and operating leases, the fact that many companies employ both, and noncancelable leases should be factored in as debt. It's all spelled out in the notes to the financial statements.
For me, it serves as another example of why the buy-and-hold strategy is so compelling. It takes time to understand a company, its industry, its financing needs, and the best way to account for its accounting practices. As long-term investors, we've got lots of time to get up to speed.
Have a great day.