Thread by @soicfinance

Do you know why the Debt to Equity of companies like Titan, Jubilant Food Works, Apollo Hospitals, has gone up significantly in the last few years?

This is due to the accounting change in leases which a retail investor must know.

Let's delve deeper to understand the cause 👇👇

It is due to Ind AS 116, which defines the accounting treatment for leases

Previously leases were treated as monthly rent expenses and charged to P&L in other expenses but post the applicability of Ind AS 116 there has been a drastic change in the books of accounts for companies

Leases now have to be shown in a company's balance sheet as both an asset and a liability. This affects the company's debt-to-equity ratio.

The liability for the lease is calculated as the current value of all the payments the company will make during the lease.
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For example, if a company has a lease that requires them to pay ₹100,000 per year for the next five years, previously this amount would have been recorded as a yearly expense on the company's P&L statement for five years.

Under the new accounting rules, it is not that simple.

Now the company has to record lease liability as Present Value of 100k for 5 yrs in the liabilities section.

Also, create an Right-of-Use asset of an amount which will be equal to lease liability (initial recognition) in the Assets side of the Balance Sheet so that BS can tally

On these lease liabilities the company will charge interest which will be reflected in P&L as finance cost.

And will also charge the depreciation on ROU Asset.

At the end of lease term both lease liabilities and ROU asset will become Nil.

Now let's understand how it will impact the key ratios of the companies due to these changes:

Balance Sheet

⏫in Assets due to ROU Asset which will look BS as asset heavy

⏫in borrowings as lease liabilities are shown under borrowings

Due to this D/E ratio will look high.

Profit & Loss Statement

- The EBITDA of companies will appear artificially strong because the lease expenses are no longer recorded as expenses on the profit and loss statement

Previously the lease expenses reduced the EBITDA, but now they don't, making the EBITDA appear higher

Next impact in P&L Statement will be:

- The finance cost and depreciation will increase because interest will be charged on the lease liability and depreciation will be charged on the Right-of-Use asset.

Net impact on P&L will be EBITDA margins ⏫ high & PBT margins ⏬ low.

Cash Flow Statement

- Cash flow from operating activities will be high as now leases expenses are not charged here it will be shown as repayment of lease liabilities which will be part of Cash flow from financing activities.
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Cash Flow from Operating activities will go up and Cash from Financing activities will be down; so all ratios related to CFO like CFO/EBITDA conversion or CFO/PAT will be higher.

🆙 Cash From Operating Activities
⏬ Cash From Financing Activities

Lets see the impact on cash flow of Jubilant FoodWorks Ltd:

The company's Cash Flow from Operations increased from 424 crore to 728 crore because a rent expense of 297 crore is now shown under Cash Flows from Financing.

Basically it has been shifted from CFO to CFF.

Let’s understand the impact of it on the P&L of Titan Ltd as they have many stores on leases:

Their Rent expenses have been reduced by 235cr and depreciation and finance cost has increased due to depreciation on ROU asset of 164cr and interest on lease liability of 106cr.
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Other example is of Rainbow Hospitals 🏥🏥

Here we can examine that EBITDA for Q2 & H1FY23 for Rainbow Hospitals stood at 25% of pre-indAS and post IndAS EBITDA stood at 30-31% due to the new amendment in IndAS where Depreciation and Interest are charged instead of rent expenses

Because of this now it has become hard to compare the numbers with previous years, as post Mar-20 the numbers are not comparable.

Let’s understand how we can change these numbers to pre Ind AS 116 and then we can compare the performance of the company with its past performance.

Following adjustments to be made; this will not give the exact numbers but we can get the approximate same numbers:

Balance sheet:
Remove lease liabilities & ROU Assets while calculating ratios like D/E, ROCE, ROA
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P&L Account

To calculate EBITDA, subtract the actual rent paid from your calculation.

This information can be found in the cash flow statement under the line item Repayment of principal portion of lease liability & Interest paid on lease liability in the CFF activities section.

With these adjustments you will get the actual pre Ind AS 116 EBITDA and these can be compared with past performance.

For PBT calculation:
Reduce the interest charged on lease liabilities from finance cost and also deduct the depreciation charged on ROU assets from D&A expenses.

Lets calculate the pre Ind AS 116 EBITDA for Devyani International from their financial statements of H1-FY23.

Pre Ind AS EBITDA = Normal EBITDA from P&L + Payment of Lease liabilities from CFS

It is also approximately matching with company's calculation mentioned in PPT.

Thank you so much for reading!!

This Sunday, a class on Valuations will be held where we will learn how to perform valuations for all industries and utilize various valuation methods.

If you wish to attend, find more details below ⤵️⤵️

https://twitter.com/soicfinance/status/1623250182359101440?s=46&t=5iRMZBkZSTzTKsAgH2yS3g