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Bank Treatment of converting operation lease to capital lease

wayne ackerman's Profile

convert operating lease to capital leaseWe just transformed $5MM of capital leases to  fmv operating lease saving $400,000 of annual cash outflow. paying the revolver down by $2MM and transferring the end of lease risk on the equipment to the lessor.   We requested bank approved which was given, but they also took the opportunity to change our leverage ratio by the almost same amount (Funded Debt/TTM EBIDTA) at the last minute so there is very little good impact left from all the hard work on our leverage ratio.  I see this as "slight of hand" becuase I might not have done the transaction had I known this would occur  . Does anybody have any thoughts on if this is normal bank behavior or unfair.   They have been a terrific bank otherwise and even here I think there is some horsetrading I can do.

 

Thanks for you thoughts

Answers

Topic Expert
Barrett Peterson
Title: Senior Manager, Actg Stnds & Analysis
Company: TTX
(Senior Manager, Actg Stnds & Analysis, TTX) |

All decent bank agreements will treat all leases, regardless of accounting classification, as debt for calculating debt and debt service coverage ratios. Leases are debt, of course, regarless of our currently defective accounting rules. The accounting rules are pending changes to require capitalization of all leases on the balance sheet as assets and debt, removing the current accounting gimickry.

Jim Schwartz
Title: Corporate financial advisor
Company: Wabash Financial Strategies
(Corporate financial advisor, Wabash Financial Strategies) |

During 35+ years in the equipment leasing industry, I've almost never seen a company make a mid-stream switch from a debt-type transaction to FMV. Barrett is correct that most banks treat long-term leases, including FMV ones, as debt equivalents. That's been the case for at least 20 years. Perhaps your bank missed the boat when it drafted the original covenants and took this opportunity to adjust things. It's not uncommon for banks to request a "quid pro quo" for approving requests like this.

It seems most useful to decide whether the company is better off in total from this transaction instead of focusing on what was "lost" on one element. Cash flow is improved and the revolver balance is lower. Depreciation deductions for and equity in the equipment have been replaced by rent expense. If the revised leverage ratio is too restrictive, present a well supported alternative to the bank. Does the bank have concerns about the credit quality or capacity of the company? Why did they feel this modification was necessary? Are there other ways to allay any concerns? The fact that you were surprised by the covenant change makes this an appropriate time to initiate a regular dialog with your bank. The aim is to minimize the likelihood of future surprises, for either side, in that relationship.

You also mentioned transferring end of lease risk to the lessor. It's not clear whether this was a goal or simply a by-product of the decision to capture cash flow savings via an FMV structure. Generally, choosing between an FMV vs. $1 purchase option lease is influenced by a company's preference for equipment use vs. ownership as well as the useful life of and ongoing need for the same or similar equipment.

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