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Subject 3. Off-Balance Sheet Leverage from Operating Leases PDF Download
Off-balance-sheet (OBS) financing is an attempt to borrow money in such a way that liabilities are kept off a firm's balance sheet and the associated interest expense off its income statement. All else equal, firms reporting operating leases will report better performance than those reporting capital leases because:

  • Their balance sheet will report less debt.
  • They will report higher profits, which appear to be generated by a relatively smaller investment in assets.

Phase 1. The Purpose for the Analysis.

The purpose of the analysis is to find any companies in the mutual fund's portfolio that might have hidden leverage and to analyze the impact of the leverage if it exists.

Phase 2. Collect Input Data.

The information source is a financial database.

The ratio is calculated as rental expense x 7.4 / total assets. 7.4 is the present value factor on a 10-year constant payment discounted at 6%.

The threshold is set to be 5%.

Phase 3 and 4. Process, Analyze and Interpret Data.

One company is identified as a potential candidate. Its operating leases are then capitalized and balance sheet amounts and ratios are revised.

Phase 5. Conclusions and Recommendations.

Once operating leases are capitalized the financial strength of the company does not appear to be that great any more. The mutual fund should decrease its holding in the company.

Phase 6. Follow-up.

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