Ind AS 116 – Dimming the light on asset lite models?

Ind AS 116 – Dimming the light on asset lite models?

India has notified Ind AS 116 (corresponding to IFRS 16)—a new accounting standard on lease—effective April 1, 2019. The most profound change introduced is the elimination of classification between operating and finance leases, thereby recognising all leases on the lessee’s balance sheet. This could, in our view, significantly impact profits and return ratios of companies with asset-light business models and having high off-balance sheet lease obligations. Other major implications are: 1) recognition of right-to-use asset (ROU; and lease liability) will dent earnings (PBT) and expand balance sheet size; 2) P&L will be exposed to volatility from foreign currency-denominated lease liabilities; and 3) significantly hit deleveraging plans of companies, especially those trying to hive-off asset-heavy businesses. In our view, although Ind AS 116 will not impact economic value of businesses, it will have significant bearing on key operating matrices of companies in certain sectors—aviation, retail, multiplex, logistics & warehousing and telecom. In this report, we evaluate ratio impacts, potential sector implications and how the transition unfolds.

 Balance sheet size of asset-light companies to expand sharply

Till now, operating leases remained completely off-balance sheet in the lessee’s books, thereby rendering many businesses asset light. Now, as per Ind AS 116, lessees will have to recognise ROU assets (and lease liability) on their balance sheets for all operating leases (subject to optional exemptions for short term, low value leases). This will enhance comparability of companies that own assets and acquire assets on lease.

Significant impact on profitability, leverage and return ratios

1) Reported EBITDA/EBIT will jump as rent expense will be replaced by depreciation and finance cost. However, PBT will be lower in initial years of the lease term owing to unwinding of higher finance cost. Extent of impact on company’s PBT is primarily contingent upon quantum of lease rent (% revenues), balance lease tenure and discount rate; 2) higher operating cash flow (OCF) will offset lower financing cash flows, keeping aggregate cash flows unchanged; 3) leverage ratios will deteriorate as debt rises and net worth declines; and 5) impact on RoCE/RoE will be higher in initial years of the lease term and wane gradually.

Sectors with high off-balance sheet liabilities to be hit the most

We have assessed the impact of Ind AS 116 on BSE-200 index companies. Our analysis indicates that profits and return ratios of companies with asset-light business models (retail, multiplex, airlines, logistics & warehousing, etc) will be impacted the most. The accounting change will also affect sectors (telecom, hotels, hospitals, etc) with high off-balance sheet lease obligations. We believe, in light of significant impact on EBITDA, leverage and return ratios, traditional valuation frameworks based on these matrices need to be revisited.

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