Are you aware how the implementation of IFRS 16 impacts the gearing ratio of companies?
Gearing, also known as financial leverage, means that a company is using debt, such as a bank loan or issued notes and bonds, as a source of financing.
Because debt financing is typically cheaper than equity financing, and in many jurisdictions interest on debt is tax-deductible, high gearing helps companies lower their overall cost of capital. It also helps companies increase the return on equity, referred to as ROE.
You can read more about gearing, what it is, and concepts like the Tax Shield in our short explainer, neatly summarised in this video:
So, in some cases high gearing could be a good sign, i.e., if a company has secured a significant amount of external debt, which translates to a reduction in its taxable income.
On the other hand, heavily geared companies are also more risky than ungeared ones.
Why is that?
Because, on the contrary to dividends, which are paid out only when a company makes profits, interest on debt has to be paid even when a company operates at a loss.
That is why the gearing ratio - that is, the share of debt financing in all the sources of capital - is one of the key ratios looked to by financial analysts. Creditor banks and bondholders often require companies’ gearing ratio not to exceed a certain level.
But what does gearing have to do with leasing and IFRS 16 in particular?
Well, under the previously effective standard on leases, IAS 17, many lease contracts, such as office space and car rental transactions, were accounted for as so-called operating leases.
That means that no assets or liabilities were recognised in the books of lessees, and rental payments were recognised in the profit or loss in periods, when they were made.
Under the new standard, the IFRS 16, the majority of such transactions will require to be recognised in the balance sheet of lessees!
That means that a company entering into a lease of office space will have to recognise an asset representing its right to use the leased office space, and also a liability to make future payments to the lessor.
Have a look at how the difference between the two standards’ requirements on reporting leases impacts another key analytic ratio, EBITDA
Although the lease liability is not classified as a financial liability in accordance with IFRS 9, it is deemed to represent the debt raised by the lessee that is used to finance the lease contract taken out from the lessor, which typically is a financial institution, such as a bank.
The economic reality is that a lease contract resembles a situation in which the lessee takes a loan from the lessor that is used to purchase the leased asset.
As a result, the lease liability is included in the calculation of the gearing ratio.
For many companies which have relied heavily on operating leases, the implementation of IFRS 16 means a significant increase of their indebtedness.
The impact on gearing is just one example of the effects of the implementation of IFRS 16.
To learn more, in detail and in practice about IFRS 16 and its consequences, you can order our IFRS 16 Update Module (and obtain your CPD certificate).