How to Forecast Operating/Finance Leases

Based on the most helpful WSO content, here’s what you need to know about forecasting operating and finance leases:

Forecasting Leases:

1. Attention to Details:

   • Analysts pay significant attention to the details when forecasting leases. This involves understanding the specific terms and conditions of each lease agreement, including the duration, payment schedule, and any escalation clauses.

2. Forecasting as a Percentage of Revenues:

   • While some analysts might use a percentage of revenues to forecast lease expenses, this approach can be overly simplistic. It’s more accurate to base forecasts on the specific terms of each lease.

3. Dealing with Lease Liabilities and Right-of-Use (ROU) Assets:

   • Initial Recognition:
     • At the inception of a lease, the lease liability is recognized at the present value (PV) of lease payments, and the ROU asset is recognized at the same amount, adjusted for any lease incentives received, initial direct costs, and restoration costs.
   • Subsequent Measurement:
     • Over time, the lease liability is reduced by lease payments and increased by interest expense. The ROU asset is depreciated over the lease term.
   • Impact on Financial Statements:
     • Income Statement (I/S):
     • For operating leases, lease expenses are recognized on a straight-line basis over the lease term.
     • For finance leases, interest expense on the lease liability and depreciation on the ROU asset are recognized.
     • Balance Sheet (B/S):
     • Initially, both the lease liability and ROU asset are recognized at the PV of lease payments.
     • Over time, the lease liability decreases as payments are made, and the ROU asset decreases due to depreciation.
     • Cash Flow Statement (CFS):
     • For operating leases, lease payments are included in operating activities.
     • For finance leases, interest payments are included in operating activities, and principal repayments are included in financing activities.

Key Points to Remember:

• Initial Recognition:
  • Lease Liability = PV of Lease Payments
  • ROU Asset = Lease Liability (adjusted for incentives, direct costs, restoration costs)
• Subsequent Measurement:
  • Lease Liability: Decreases with payments, increases with interest
  • ROU Asset: Decreases with depreciation
• Financial Statements Impact:
  • I/S: Operating lease expenses vs. finance lease interest and depreciation
  • B/S: Initial recognition of liabilities and assets, subsequent reduction
  • CFS: Operating vs. financing activities for lease payments

By understanding these intricacies, analysts can more accurately forecast the impact of leases on a company’s financial statements.

Sources: Beyond the guide: a list of real interview technical questions, Associate guide on analyzing an income statement, Overview of Leveraged Finance, Life in Acquisitions (Analyst/Associate), Leveraged Finance – 2017 Update