What is Debt?

As announced in my previous post about IFRS 16 Leases, this follow-up post dicusses the question of What is Debt? . First, I describe common Features of Debt and Leasing Liabilities as well as answering Why to treat them as Debt. Then I discuss What Items to include in Debt and How to calculate Net Debt. Finally I give a Summary of the article and an Outlook on a further follow-up post discussing How to incorporate Net Debt within a DCF Valuation.

Features of Debt

I’d like to refer to a slide by Damodaran for the charactarization of debt

Aswath Damodaran (link)

Leasing Liabilities & Why to treat them as Debt

Before IFRS 16 adoption, in fact many valuation experts argued for a long time to include leasing liabilitites when calculating (net) debt. As written in another post, leasing liabilities represent future lease payments discounted with an appropriate discount factor. As they match the above criteria for debt, they should be included when calculating (net) debt. In 2009, Damodaran wrote :

Many firms that use long-lived, expensive assets for their operations have a choice of either buying these assets, often borrowing a significant portion of the costs, or leasing them. Since the firm puts the assets to use, generating revenues and operating profits, in either case, it seems logical to consider leasing as a financing choice and leasing costs as financing costs. Unfortunately, both US and international accounting standards choose to ignore this logic and allow a significant portion of lease expenses to be treated as operating expenses. Consequently, the operating income of a firm that has significant operating lease expenses will be misstated, as will the reported book values of debt and capital. If we use these reported numbers in analyzing the firm, we will arrive at skewed estimates of profitability, leverage and value.

Damodaran (2009): Leases, Debt and Value

Damodaran therefore recommended the following (before IFRS 16 implementation) when calculating (net) debt:

There are therefore two adjustments we will make when we estimate how much debt a firm has outstanding.
(i) We will consider only interest bearing debt rather than all liabilities. We will include both short term and long term borrowings in debt.
(ii) We will also capitalize operating leases and treat these expenditures as financing expenses.

Damodaran: What is Debt?

Debt

Based on the written above, Debt or more specific interest bearing debt (IBD) is calculated as the sum of the following accounting items

  • Short-term Debt
  • Long-term Debt
  • Leasing Liabilities
  • (Pension Liabilities)

Net Debt

Net debt basically illustrates how much debt was left, if cash and cash equivalents (as marketable short term securities) were used to pay down debt.

ND = IBD – Adj. Cash & Cash Equivalents.

Summary

Learnings were, accounts payable are not but leasing liabilities are to be included when calculating Debt besides short- and long-term debt.

Outlook

Capitalized leasing liabilities only capture current leasing contracts with their respective contract maturities. Since leasing payments will likely occur into perpetuity, these need to be captured somehow when performing a DCF Valuation, see my next post.

Best, s4v
And a happy New Year 2020 to everyone!

2 thoughts on “What is Debt?

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s