To consider the financial statement effects of leasing versus purchasing an asse

Question

To consider the financial statement effects of leasing versus purchasing an asset, review the following case of Mitata Company Mitata Company needs equipment that will cost the company $800. Mitata Company is considering to either purchase the equipment by borrowing $800 from a local bank or leasing the equipment. Assume that the lease will be structured as an operating lease Some data from Mitata Company's current balance sheet prior to the lease or purchase of the equipment are Balance Sheet Data (Dollars) $4,200 Debt Current assets Net fixed assets Total assets 1,800 Equity $6,000 Total claims $2,400 3,600 $6,000 1. The company's current debt ratio is 2. If the company purchases the equipment by taking a loan, the total debt in the balance sheet will , and the debt ratio will change to 3. If the company leases the equipment, the company's debt ratio will because the lease is not capitalized 4. In this case, the company's financial risk will be under a lease agreement as compared to the financial risk in purchasing the equipment by taking a loan 5. However, if the lease is capitalized, the financial risk under the lease agreement will be as compared to the risk in buying the equipment

Explanation / Answer

The debt ratio is defined as the ratio of total debt to total assets.

Hence, in question, debt ratio = 2400/6000 = 40%

If the company purchases the equipment by taking a loan, the total debt in the balance sheet will INCREASE, and the debt ratio will change to 53% (Total debt = 2400 + 800, Total Asset = 6000, debt ratio = 3200/6000 = 53.33%)

If the company leases the equipment, the company's debt ratio will REMAIN UNCHANGED. (Operating leases stay off the balance sheet, they just appear on income statement as rent expense)

In this case, the company's financial risk will be LESS under a lease agreement as compared to the financial risk in purchasing the equipment by taking a loan. (since operating lease stays away from balance sheet, so no risk)

However, if the lease is capitalized, the financial risk under the lease agreement will be SAME as compared to the risk in buying the equipment. (since a capital or financial lease will be recorded in balance sheet as an asset and liability)

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