Company valuations and the new IFRS 16 leases standard
May 2018
There has been a lot of buzz around the new IFRS 16 leases standard, which comes to effect from the beginning of 2019. The new standard requires lessees to recognize nearly all leases on the balance sheet, which will reflect their right to use an asset for a period of time and the associated liability for payments.
How is this new standard connected to company valuations if there are no cash flow effects? The majority of companies use rentals or leasing as means to obtain access to assets. However, they are often considered as off-balance sheet items. The new requirements eliminate nearly all off-balance sheet accounting for those companies that use leased assets and will affect virtually all commonly used financial ratios and performance metrics. Examples of metrics affected by the new requirements are gearing, current ratio, asset turnover, interest cover, EBITDA, EBIT, operating profit, net income, EPS, ROCE, ROE and operating cash flows. Therefore, these changes may affect loan covenants, credit ratings and borrowing costs, and could result in behavioral changes, most obviously in how companies make use of leasing.
Under existing rules, the leasing expense is recognized above EBITDA in the P&L, hence decreasing EBITDA. Under the new rules, all future lease payments are discounted to present value and recognized on the balance sheet as assets, which are depreciated over their useful life. Consequently, the leasing expense is moved below EBITDA as a depreciation item. As a result, EBITDA will increase.
Will this change have an effect on valuation multiples? Different implications may arise for different industries when adopting the new leases standard. Generally, if EBITDA will increase then the EV/EBITDA multiple will decrease. However, EV/EBIT multiple will not be much affected, nor will the EV/Sales multiple.
Which industries are most affected by the new rules? Although virtually every industry uses leasing as means to obtain access to assets, the type and volume of assets that they lease, as well as terms and structures of the lease agreements differ significantly. For example, a professional services firm leases cars and corporate offices; a utilities company leases power plants; a retailer leases retail stores; a telecoms entity leases fibre otic cables and cell towers; and an airline leases aircraft – all with very different characteristics, terms, regulatory frameworks, pricing, risks and economics.
PwC has conducted a global lease capitalization study to assess the impact of the new leases standard on reported debt, leverage, solvency, and EBITDA for a sample of more than 3,000 listed entities reporting under IFRS across a range of industries and countries (excluding the US). The research identifies the minimum impact of capitalizing existing off-balance sheet operating leases based on commitments disclosures in entities’ published financial statements in 2014. The research does not take into account any transitional reliefs that may be available on adoption of the new standard. The median increase in debt and EBITDA for some of the most impacted industries can be summarized as follows.
There has been a lot of buzz around the new IFRS 16 leases standard, which comes to effect from the beginning of 2019. The new standard requires lessees to recognize nearly all leases on the balance sheet, which will reflect their right to use an asset for a period of time and the associated liability for payments.
How is this new standard connected to company valuations if there are no cash flow effects? The majority of companies use rentals or leasing as means to obtain access to assets. However, they are often considered as off-balance sheet items. The new requirements eliminate nearly all off-balance sheet accounting for those companies that use leased assets and will affect virtually all commonly used financial ratios and performance metrics. Examples of metrics affected by the new requirements are gearing, current ratio, asset turnover, interest cover, EBITDA, EBIT, operating profit, net income, EPS, ROCE, ROE and operating cash flows. Therefore, these changes may affect loan covenants, credit ratings and borrowing costs, and could result in behavioral changes, most obviously in how companies make use of leasing.
Under existing rules, the leasing expense is recognized above EBITDA in the P&L, hence decreasing EBITDA. Under the new rules, all future lease payments are discounted to present value and recognized on the balance sheet as assets, which are depreciated over their useful life. Consequently, the leasing expense is moved below EBITDA as a depreciation item. As a result, EBITDA will increase.
Will this change have an effect on valuation multiples? Different implications may arise for different industries when adopting the new leases standard. Generally, if EBITDA will increase then the EV/EBITDA multiple will decrease. However, EV/EBIT multiple will not be much affected, nor will the EV/Sales multiple.
Which industries are most affected by the new rules? Although virtually every industry uses leasing as means to obtain access to assets, the type and volume of assets that they lease, as well as terms and structures of the lease agreements differ significantly. For example, a professional services firm leases cars and corporate offices; a utilities company leases power plants; a retailer leases retail stores; a telecoms entity leases fibre otic cables and cell towers; and an airline leases aircraft – all with very different characteristics, terms, regulatory frameworks, pricing, risks and economics.
PwC has conducted a global lease capitalization study to assess the impact of the new leases standard on reported debt, leverage, solvency, and EBITDA for a sample of more than 3,000 listed entities reporting under IFRS across a range of industries and countries (excluding the US). The research identifies the minimum impact of capitalizing existing off-balance sheet operating leases based on commitments disclosures in entities’ published financial statements in 2014. The research does not take into account any transitional reliefs that may be available on adoption of the new standard. The median increase in debt and EBITDA for some of the most impacted industries can be summarized as follows.
Under the new rules, all future lease payments are discounted to present value and recognized on the balance sheet as assets, which are depreciated over their useful life.
