Impact of Capitalizing the Value of Operating Leases
Response to the following problem:
The following information comes from the financial statements of Travis Campbell Company:
Total liabilities................................$100,000
Total stockholders' equity.................80,000
Property, Plant, and equipment.........110,000
Sales..............................................500,000
Earnings before income taxes............11,000
Interest expenses.............................23,000
In addition, Travis Campbell has a large number of operating leases. The payments on these operating leases total $30,000 per year for the next 10 years. The present value of the economic obligation associated with these operating leases is $180,000. Of course, because these are operating leases, this economic obligation is off the balance sheet.
Required:
Compute the following ratio values:
1. Debt ratio.
2. Debt ratio assuming that Travis Campbell's operating leases are accounted for as capital leases.
3. Asset turnover (sales/total assets).
4. Asset turnover assuming that Travis Campbell's operating leases are accounted for as capital leases.
5. Interpretive Question: You are Travis Campbell's banker. You are concerned that the times interest earned ratio is not accurately reflecting the risk that Travis Campbell will not meet its fixed annual payments because most of those fixed payments are operating lease payments, not interest payments. Design an alternative ratio that will reflect the fact that, like interest payments, operating lease payments are fixed obligations that must be covered through operating profits each year. Compute the value for the ratio that you have designed.