Complicated analysis of "light assets"

IFRS 16 in the credit analysis of non-financial companies

IFRS 16 is intended to provide comparability of financial metrics of companies applying different asset ownership models, but still there is a lot of lease accounting nuances in credit analysis.

On January 1, 2019, IFRS 16 Leases came into force. The new standard affected the structure of financial statements of multiple companies. One of the main objectives was to introduce a single accounting model for corporates applying different asset ownership approaches. In this analytical commentary, we will focus on the key provisions of IFRS 16 and ACRA's approaches to the use of this standard in credit analysis.

Why was IFRS 16 introduced?

In some industries with a highly volatile demand, players need to have the most flexible operating model. A typical example of this is the transport industry, where carriers increase their carrying capacity when macroeconomic indicators grow and reduce it in times of crisis. This flexibility is achieved through the lease of fixed assets. This model is known as the "light assets" model because leased assets are not recognized in the balance sheet. This model has also become widespread in the retail sector, where retailers can manage its business more efficiently by renting, not buying, sales areas. Thanks to this, they always have the opportunity to quickly close out the stores that have failed to reach their targets or ceased to be profitable.

Another strategy (aka the "heavy assets" model) is less flexible but it does not mean that there is no economic sense in using it. This strategy is applicable, in particular, in those markets where demand is less volatile, and market players can make plans for their fixed assets for longer terms. Under such model, leases imply a standardized product that can be offered to a relatively large number of potential lessees. So, if a retailer needs specific sales areas (like hypermarkets, which are often located in separate buildings), retailers focused on this format sometimes build them independently, attracting debt financing for this.

Until recently, the different models resulted in significant discrepancies in the financial statements of retailers: one company would reflect its expenses for distribution network as operating expenses in the form of leases and the other — as financial expenses in the form of interest payments. Differences were also in balance sheet indicators: in the first case, there was no debt in liabilities. Furthermore, assuming that these companies are extremely similar in everything except their asset ownership models, then, in the first case, the operating profitability would be lower, and in the second, the leverage would be higher. In other words, the difference in estimated financial conditions of the companies would depend solely on the form of asset ownership.

In an effort to neutralize this effect, credit analysts have developed their own methods and approaches. For example, they compared operating income before lease expenses and included the estimated amount of debt that could be raised to purchase the leased assets into the calculations of leverage. Given this variability, the leases accounting approaches were refined, which eventually resulted in IFRS 16.

Use of IFRS 16 in credit analysis

After the standard was introduced, financial reports of transportation, retail trade, telecommunications, and some other industries changed significantly. In the balance sheet's assets section, the right-of-use assets appeared, which included both financial and operating leases, and a corresponding item appeared in the liabilities section. In the income statement and the cash flow statement, operating leases are no longer presented as a single line within operating expenses, but they are divided into principal and interest. In addition, the operating lease is now included into amortization of lease rights, interest and principal payments.

Now, some of the actions that credit analysts previously took with the reports to achieve comparability of different asset ownership models are reflected in these reports themselves, which made the analysis easier and more correct. On the other hand, certain difficulties emerged as well. The analysis and calculation of forecasted lease payments have become somewhat more complicated, and for the industries that IFRS 16 impacted first, these payments form one of the main items of operating expenses. FCF estimations also need to be adjusted for lease payments, which are now reflected in the reports as part of debt repayment.

It should be understood that the nature of the liabilities that are included into the balance sheet in accordance with the standard is fundamentally different from what is taken into account in credit analysis.

At its core, IFRS 16 determines the amount of liabilities to lessors based on the terms of lease agreements, taking into account the amount of lease payments, lease term, and the change in the value of money over time. Accordingly, the shorter the term of a lease agreement, the lower the amount of liabilities. Credit analysis proceeds from a different economic sense: the monetary burden on the business, whether arising out of the lease of a fixed asset or its acquisition using borrowed funds, is comparable, therefore, the amount of debt on the lessee's balance sheet should be close to that of a company that bought such asset.

From the viewpoint of credit analysis, the term of lease agreement does not really matter: if a company needs a certain number of aircraft and it makes corresponding amount of lease payments annually, then, if the volume of business is maintained, the company will continue to use these aircraft and make comparable lease payments, regardless of the term of lease agreements. The analyst should take into account that under IFRS 16, liabilities and lease rights are amortized over time. This leads to a decrease in the amount of liabilities on the balance sheet, without any actual changes in a company, while the amount of real lease payments remains the same.

In addition to the specifics described above, IFRS 16 has a set of criteria that make it possible not to use new approaches, and therefore some companies (albeit few) have retained the same reporting structure. Therefore, in order to make a correct comparison, analysts need to somehow equalize three groups of companies: those applying the "heavy assets" model, those applying the "light assets" model and reflecting leases in accordance with IFRS 16, and those applying the "light assets" model except the new accounting principles for leases.

ACRA's approaches

In view of the above, ACRA decided to maintain its approaches to accounting for leases in its credit analysis. As before, the Agency analyzes leverage of companies in the transport, retail trade and telecommunications sectors using the multiplier method.

Under such approach, an annual lease payment is multiplied by a factor determined by the type of leased asset, which allows us to calculate the comparable amount of debt that would have been raised to purchase such asset. As regards the profit and loss statement and the cash flow statement, ACRA analysts transform these two forms to the previous methods of presentation of leases and make calculations based on the data adjusted in this way.

This approach allows the Agency to determine the adjusted debt based on real rental costs. As a result, leverage of companies with long-term lease agreements, according to ACRA's calculations, may be less than the leverage calculated based on reports under IFRS 16. Accordingly, the situation is reverse for companies with short-term lease agreements.

To achieve the most comprehensive and fair view, ACRA uses in its analysis, for a number of industries, indicators that both include debt adjusted for operating lease and exclude such debt (i.e. include only debt funding). These two approaches are not interchangeable: it is not possible, in some cases, to include leases in calculations, and, in the others, not to include, since the boundaries of factor estimates differ significantly.

The use of two groups of such indicators, on the one hand, is due to the fact that non-performance of operating lease obligations is most often not an event of default for a company and its debt obligations (as per the Key Concepts Used by the Analytical Credit Rating Agency in Rating Activities), although it can impair assessments for a number of rating factors, while non-payment of loans or borrowings is always an event of default. When two groups of indicators are used, the weight of bank and bond debt increases in a certain way. On the other hand, as mentioned above, the "light assets" model increases business agility, and low-leverage companies applying this model have a slight positive effect on their credit rating.

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