Lease Adjusted Leverage Under ASC 842: Debt, EBITDAR and a Worked Ratio
Lease adjusted leverage is a credit metric that treats leases like loans. It adds lease liabilities to debt, then divides by EBITDAR: EBITDA with rent added back. ASC 842 put lease liabilities on the balance sheet, but it does not call the operating lease kind debt. So whether they count depends on who is doing the math, and on the terms of the loan.
This page covers what the standard says, how a lender or analyst might adjust, and one worked example. It is general information, not credit, lending or investment advice. Your credit agreement's terms control your covenant math.
What is lease-adjusted debt?
Lease-adjusted debt is funded debt plus the leases an analyst chooses to treat as debt. Funded debt is the term loan, the revolver and any notes. The lease piece is where the methods split. Some add only finance leases, some add all leases, and some estimate the lease piece from a year of rent.
The idea is older than ASC 842. A firm that rents its warehouses has a fixed claim on its cash, much like one that borrowed to buy them. KPMG's Handbook: Leases notes that "most financial statement users (e.g. investors and analysts) already adjust lessees' financial statements for operating lease obligations."
What changed is the starting number. Under ASC 842-20-30-1, a lessee measures the lease liability at "the present value of the lease payments not yet paid." That figure now sits on the balance sheet. An analyst can pick it up instead of guessing.
Do operating lease liabilities count as debt?
No. Under ASC 842-20-45-1, a lessee shows "finance lease liabilities and operating lease liabilities separately from each other and from other liabilities," on the balance sheet or in the notes. ASC 842-20-45-3 bars the two from the same balance sheet line.
That description is in the FASB's basis for conclusions, which is not part of the Codification. Paragraph BC14 of ASU 2016-02 says "Topic 842 characterizes operating lease liabilities as operating liabilities, rather than debt." KPMG's Handbook says the same of how they are presented and accounted for: "as operating liabilities, rather than as debt" (KPMG Handbook: Leases, paragraph 6.9.60).
KPMG gives the Board's main reason in paragraph 6.9.90. Operating lease liabilities are not debt-like in nature. In a bankruptcy, for example, they are generally treated differently from finance lease obligations.
On the books, the operating lease line sits with other operating items, not with notes payable. Its current part still goes in current liabilities on a classified balance sheet. KPMG reads ASC 842-20-45-1 that way, with the split made under Topic 210. Lease liabilities are classified "in the same manner as any other" financial liability (KPMG Handbook: Leases, paragraph 6.9.40 and Question 6.9.10).
None of that stops a lender from adding the line to debt. ASC 842 governs how you show the number. It does not govern how a loan or an analyst defines leverage.
Where do finance lease liabilities fit in a debt definition?
Finance leases sit much closer to debt. Deloitte's Roadmap: Leasing, section 14.2 explains why the Board kept them apart. Citing BC57 of ASU 2016-02, it says "finance lease liabilities are the equivalent of debt and are generally treated as such in the event of an entity's bankruptcy."
The income statement treats them like debt too. Under ASC 842-20-45-4(a), a lessee shows finance lease interest the same way as its "other interest expense." Amortization of the right-of-use asset follows its other depreciation and amortization. So both costs land below EBITDA.
Operating leases work the other way. Under ASC 842-20-45-4(b), their lease expense goes in "income from continuing operations." That cost sits above EBITDA, so it lowers it. Under ASC 842-20-25-6(a), it is a single lease cost, generally spread on a straight-line basis, so it can differ from the cash rent paid that year.
That split drives the math. A finance lease can join debt with no change to EBITDA, since its costs are already below the line. An operating lease needs its rent added back, or the ratio counts the same lease twice. For the entries behind each line, see operating vs. finance lease journal entries.
How is the lease-adjusted leverage ratio calculated?
Take a made-up private distributor, Harbor Supply Co., at year-end. Every input is stated, so you can check each step. The figures are for show. The measures are common forms, not any one lender's or rating agency's formula.
| Input | Amount |
|---|---|
| Funded debt (term loan and revolver) | $12,000,000 |
| Finance lease liabilities (current and noncurrent) | $1,500,000 |
| Operating lease liabilities (current and noncurrent) | $6,000,000 |
| EBITDA for the year | $5,000,000 |
| Operating lease cost for the year (in EBITDA) | $1,200,000 |
| EBITDAR (EBITDA + operating lease cost) | $6,200,000 |
| Measure | Top | Bottom | Ratio |
|---|---|---|---|
| 1. Debt / EBITDA | $12,000,000 | $5,000,000 | 2.40x |
| 2. (Debt + finance leases) / EBITDA | $13,500,000 | $5,000,000 | 2.70x |
| 3. (Debt + all lease liabilities) / EBITDAR | $19,500,000 | $6,200,000 | 3.15x |
| 4. (Debt + finance leases + 8 × rent) / EBITDAR | $23,100,000 | $6,200,000 | 3.73x |
Measure 1 leaves leases out. Measure 2 adds the finance lease line, which a loan's debt terms may already include. Measure 3, the lease-adjusted form, adds $12,000,000, $1,500,000 and $6,000,000 to get $19,500,000. Divided by $6,200,000, that is 3.145, or 3.15x.
Measure 4 shows the shortcut of sizing lease debt from rent. The multiple is the analyst's own pick; 8 is used here only to show the math. Rent of $1,200,000 times 8 is $9,600,000. Add $13,500,000 to get $23,100,000, then divide by $6,200,000 for 3.73x.
The same firm reads anywhere from 2.40x to 3.73x. None of them is the right one. Each answers a different question, so a covenant test uses the one the loan defines. For how the ratios on the face of the statements moved, see ASC 842 and your ratios.
Why does the credit agreement decide the answer?
Because a covenant is a contract term, not an accounting rule. The loan defines debt, EBITDA and leverage in its own words. Some name capital leases (the ASC 840 term older agreements still use) or finance leases as debt. Some say nothing of operating leases, and some leave them out on purpose.
Many loans also lock in the rules they rely on. BC14 of ASU 2016-02 notes that "a significant portion of loan agreements contain 'frozen GAAP' or 'semifrozen GAAP' clauses." Under such a clause, a ratio change caused only by new GAAP is not a default. Or it sends both sides to work out terms in good faith.
Read the terms and that clause before you sign the compliance certificate. The terms and that clause decide the covenant math, not the standard. A bank may track lease-adjusted leverage for its own file while the covenant uses plain debt to EBITDA. Our loan covenant guide covers what to check.
Does the private company discount rate election change the number?
It can. When the rate in the lease is not readily known, ASC 842-20-30-3 lets a lessee that is not a public business entity use a risk-free rate. It elects this by class of asset, in place of its incremental borrowing rate.
A risk-free rate is most often lower than what the firm pays to borrow, and a lower rate gives a higher present value and a larger lease liability. Lease-adjusted debt built from the balance sheet rises with it, and so does the ratio. The election is disclosed in the notes, including the asset classes it covers (Deloitte, Roadmap: Leasing, section 7.2.3). That way a reader comparing Measure 3 across companies can see which rate each used.
Frequently asked questions
What is EBITDAR?
It is EBITDA with rent added back. The R stands for rent. In practice the add-back is the year's lease cost. Each lender or analyst says which rent goes back in, so read the terms before you compute it.
Why add rent back to EBITDA when you add lease liabilities to debt?
To keep the two sides in step. Once the lease sits in the top of the ratio as debt, its rent should not also cut the earnings at the bottom. Adding rent back treats the lease like a loan on both sides.
Is lease-adjusted leverage the same as the debt-to-equity ratio?
No. Debt-to-equity weighs debt against the owners' stake on the balance sheet. Lease-adjusted leverage weighs debt plus leases against a year of earnings before rent. It reads as roughly how many years of earnings before rent it would take to cover what is owed.
Sources and further reading
- FASB, ASU 2016-02, Basis for Conclusions, paragraph BC14, as reproduced on PwC Viewpoint.
- Deloitte, Roadmap: Leasing, section 14.2, Lessee presentation (ASC 842-20-45-1, 45-3 and 45-4).
- KPMG, Handbook: Leases, Question 6.1.10, Question 6.9.10, and paragraphs 6.3.60, 6.9.40, 6.9.60 and 6.9.90.
- How ASC 842 affects company KPIs and performance metrics
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