Last Updated on February 9, 2023 by Morgan Beard
Many businesses have only recently adopted ASC 842, the new lease accounting standard, pending their effective dates. Finance teams are just now looking at how it affects financial ratios and metrics. As one of the more popular metrics used to informally gauge a company’s financial health, it’s important to understand ASC 842’s effect on EBITDA.
For those unfamiliar with the term or what it means, here’s a brief primer to get you up to speed.
What Is EBITDA?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. The formula to calculate EBITDA is very simple—just sum up the total amount of interest, tax, depreciation, and amortization expenses, then add that figure back to net income. By eliminating the impact of non-operating management decisions, such as tax rates and interest expenses, EBITDA places a heavy focus on the financial outcomes of operating decisions.
Perhaps the best way to think of EBITDA is as a measure of a company’s ability to generate cash. While cash is an important consideration, it’s not the only measure of financial health. Critics of EBITDA contend that it can lead to overestimating a company’s profitability. Interest, tax, depreciation, and amortization are often seen as “drags” on profitability, and EBITDA essentially discards them. But all of these items have a significant effect on the balance sheet.
Still, as a metric for comparing companies (or even a single company over a period of time), EBITDA gives a fairly realistic view of profitability. Investors tend to focus on net income, revenue, and cash flow, and EBITDA is an easy way to analyze and compare profitability between companies and industries.
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Why Is EBITDA Important?
Beyond its popularity with non-accountants, EBITDA is important because it’s used as the basis for other calculations and ratios. After determining EBITDA, a typical next step is to figure out whether the calculation reflects a profitable standing. ASC 842 foundationally impacts your EBITDA. One of its more popular variations is EBIT. As the name implies, EBIT does not add depreciation and amortization back to net income.
Some of the more popular next steps include calculating the EBITDA margin, EBITDA coverage ratio, and adjusted EBITDA.
EBITDA margin compares calculated EBITDA against a company’s overall revenue, in an effort to determine the amount of cash profit a company makes in a year. If your company’s EBITDA margin is greater than the EBITDA margin of other businesses, it’s a good indicator that your company has greater growth potential. The formula EBITDA margin is calculated as EBITDA divided by total revenue.
EBITDA Coverage Ratio
You can think of the EBITDA coverage ratio as another way to put EBITDA value in the proper context. It’s effectively a solvency ratio that measures the ability of a business to pay off its debts and lease liabilities using EBITDA. After the EBITDA calculation, you arrive at the EBITDA coverage ratio by dividing the sum of lease payments and EBITDA by the sum of principal and interest payments and lease payments. The formula looks like this: (EBITDA + Lease Payments)/(Interest Payments + Principal Payments + Lease Payments)
The distinction between EBITDA and adjusted EBITDA is minor, but it is important. Adjusted EBITDA normalizes EBITDA by removing operational anomalies like owner bonuses, rent paid above market value, litigation expenses, and a single-time loss or gain. As adjusted EBITDA is dependent on each company’s circumstances, there is no standardized formula. It’s typically the job of a financial analyst to decide what anomalies should be removed when calculating adjusted EBITDA.
Leases in Financial Statements
Before looking at the impact of the Financial Accounting Standards Board, ASC 842, on EBITDA, it’s important to recall the major lease accounting changes in the new standard. To recap, under ASC 842, there are two lease classifications: operating leases and finance leases. The income statement and statement of cash flows are largely unchanged. In particular, operating leases are still expensed on a straight-line basis on the income statement, and the interest on finance leases is still an expense on the income statement.
In the statement of cash flows, operating leases are now included in the operating activities section. For finance leases, payments of lease principal are included in the financing activities section, and the interest portion in the operating activities section.
On the balance sheet, the treatment of finance leases is similar to that of capital leases under ASC 840 and other previous guidance. However, the treatment of operating leases has a significant reporting change from previous guidance.
Historical accounting guidance, before ASC 842, operating leases were not required to be recorded on the face of a company’s financial statements—they only had to be included in the notes. Under the new standard, operating leases are recorded on the balance sheet and reflected as a right of use (ROU) asset and a corresponding lease liability. Which not only has a material impact but expense recognition of the underlying asset, in accordance with the updated generally accepted accounting principles, will affect your financial statements.
ASC 842’s Impact on EBITDA
It’s this new requirement that operating leases be recognized on the balance sheet—and the corresponding effect on the income statement—that could have an impact on key ratios and, ultimately, on EBITDA, and your organization’s financial position.
For example, consider an operating lease under ASC 842 where the leased asset, like a real estate lease, is classified as a long-term asset while the corresponding lease liability is separated into short-term and long-term liabilities. Comparing the accounting under prior guidance to accounting under ASC 842, the ROU would add to the figures for non-current assets, current liabilities, and non-current liabilities.
The net result will be a slightly lower current ratio (the value of current assets divided by current liabilities). Other ratios affected would include the debt to net worth ratio, funded debt to EBITDA, and debt service coverage.
Streamline ASC 842 Lease Accounting with Occupier
Ultimately, the lease accounting changes in ASC 842 should not significantly impact a business valuation. However, the calculation of cash flows, discount rates, and other figures can significantly impact the bottom line if accounting practices are not carefully considered. To ensure lease accounting that’s both accurate and optimized for your financial ratios, you need a system built for the task. Occupier’s products and services were built to ensure ASC 842 compliance, giving you the best results in your financial reporting.
We leverage a modern and innovative tech stack that takes all the worry out that comes with the changes in standards. If you’re ready to see how Occupier can streamline your entire lease accounting lifecycle, get in touch with us today and schedule a demo.
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