Financial leverage

New supplier finance disclosures will affect operating cash flow

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Reported operating cash flow, leverage and net working capital measures, may be misleading if a company engages in supply chain financing. The impact can be significant but, at present, calculating the effect and making adjustments is difficult. Additional IFRS disclosures proposed by the IASB will help.

We explain the new disclosures and provide an interactive model to illustrate how to use them to calculate more realistic measures of cash flow, leverage and working capital. The adjustments depend on whether liabilities are classified as trade payables or debt finance and may require the inclusion of a non-cash ‘effective’ operating cash outflow.

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Convertible accounting: New US GAAP inflates earnings

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Changes to convertible bond accounting under US GAAP will mean higher reported debt but, paradoxically, a lower (and sometimes zero) interest expense. In our view, the resulting increase in earnings is artificial, fails to faithfully represent the cost of convertible financing and will not benefit investors.

The recent surge in convertible issuance, and the use of so-called convertible bond hedges, may have more to do with favourable accounting than favourable economics. We use the recent convertible issue by Twitter to illustrate the revised US GAAP and compare this with the more realistic approach under IFRS.

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Sale and leaseback: Operating risks and reporting anomalies

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It is important to consider the impact of different leasing structures on operational risk, in addition to financial leverage. Leases with variable payments reduce operating risk, but sale and leaseback transactions may have the opposite effect. We use hotel company International Hotels Group and airline EasyJet to illustrate.

IFRS accounting for leases with variable payments and for sale and leaseback transactions is clear. However, combining the two in one transaction is more problematic. The IASB’s recently proposed amendment to IFRS 16 would bring leases with variable payments arising from sale and leaseback transactions onto the balance sheet. We explain why we disagree.

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Pension leverage under IFRS and US GAAP

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US GAAP and IFRS present the effects of pension leverage differently in financial statements, notably leverage arising from pension fund asset allocation. This complicates the comparison and interpretation of performance measures and valuation multiples.

We use Delta Air Lines to illustrate the positive impact of the US GAAP ‘expected return’ approach on reported profit, including the effect of optimistic return assumptions. If Delta had applied the IFRS ‘net interest’ approach we estimate that a ‘gain’ of $594m would have been excluded from profit and loss and instead reported in OCI.

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Allocating value: An option-based approach

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You might assume that a change in enterprise value completely accrues to equity investors; however, this is often not the case. Other claims, such as debt or equity warrants, also change in value as enterprise value changes. Understanding this effect can be important when analysing many companies, especially those in financial distress.

Option-like characteristics of debt and equity claims drive the allocation of changes in enterprise value between debt and equity investors. We apply an interactive model to analyse recent changes in the enterprise value of Air France–KLM.

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Leasing and leverage – credit rating agencies disagree

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Rating agency Fitch recently announced its approach to dealing with the new lease accounting in its credit metrics. Their approach is at odds with that already published by Moody’s and Standard & Poor’s. Of particular interest is the way the rating agencies deal with the differences between IFRS and US GAAP.

We explain the different approaches of the rating agencies, how we think investors should calculate key metrics, such as leverage and cash flow, and the importance of considering the impact of leasing on operating leverage and business flexibility.

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Leverage and cash flow effects of supply chain finance

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Supply chain finance, such as factoring and reverse factoring, are often labelled as tools used by companies in financial distress. Although we believe they are valid financing techniques, the reporting of these arrangements can affect leverage and cash flow. Due to poor disclosure you may not even know about it. 

Debt finance may not appear as debt in the balance sheet.  Operating cash flows may not include payments for some operating expenses or may be distorted by changes in financing being classified as operating. We explain how supply chain finance works and how you may need to adjust key metrics.

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