DuPont Analysis

While making my way through the Chartered Financial Analysis (CFA) level 1 curriculum in the Financial Reporting and Analysis (FRA) section, I encountered one of the most important tools in financial statement analysis--the DuPont Analysis. I’d like to take a moment to explain not only the process for completing this analysis but also breakdown the potential usefulness of it.

We will begin the conversation with the ratio known as return on equity or ROE. This is a measure of the total return based on the amount of book equity the firm has in its capital structure. Return is simply net income as this is the allocation of earnings that equity investors have title to. The simplest form of the DuPont analysis breaks the ROE calculation into two portions, the first is return on assets (ROA) and the second is the financial leverage ratio. ROA can be viewed as a measure of how efficiently the firm is utilizing the assets they have while the financial leverage ratio (sometime called the equity multiplier) is the amount of debt in proportion to the amount of equity a firm has within this capital structure.

 This shows us that changes in ROE can be linked to either a change in the return on assets or the amount of leverage used within the business. While this is a base line equation, we can continue to break this down further. We can next break the ROA into two separate factors, net profit margin and asset turnover.

In doing this breakout, we are not able to determine that changes in ROE can be attributed to changes in net margins, asset efficiency (asset turnovers) and use of leverage.

The last step to breaking out the DuPont equation is taking a look at net profit margin. We can view net profit margin as a function thee key areas, the first of which is the earnings before interest and taxes (EBIT) margin, sometime referred to as the operation margin. This is the income the firm earned from normal operations without consideration of capital structure. The second factor is the interest burden which takes earnings before taxes (after interest) and compares it to EBIT. This will indicate how much of the firm’s earnings are being used to service the debt within the capital structure. The last factor is the tax burden which shows us the firm’s tax rate. 

This allows us to analyses changes in the net profit margin of the firm based on operating changes (EBIT margin) changes in debt service costs (interest burden) and tax rates. Finally, we can combine all these calculations to end with the five step DuPont analysis of ROE.

Apply simply cross multiplication and this equation breaks down to net income over equity, or ROE. As analyst, we are able to look at ROE of a firm and determine what factors have helped the firm achieve their given ROE. More importantly, we can analyses time-series data and determine what is causing changes in ROE form one period to another. For example, if a firm has a 10% increase in ROE year over year and you apply the DuPont analysis to determine that this change is caused by an increase in the use of leverage it will be much less favorable than an identical firm which had the same 10% increase due to improved efficiency or margins (asset turnover or EBIT margin). 

My CPA Exam Journey

I have been asked by the student accounting group at my graduate program to talk to both undergrad and graduate accounting students about my journey throughout the CPA exam. As almost all of these students are in the process of, or planning on soon sitting for the exams, I hope sharing my experience will be helpful in better preparing them to pass. While I am in no way a “CPA Guru,” I have taken the exam very recently and can share the tips and tricks I learned along the way. Hope you enjoy.

Let us begin by talking about the structure of the Uniform CPA exam. As of 2013, the exam consisted of four individual sections. These sections are Auditing & Attestation (AUD), Business Environment & Concepts (BEC), Financial Accounting & Reporting (FAR), and Regulation (REG). Other sources will better explain the content of each exam. Each consists of four testlets, the first two have three multiple choice sets with 24 questions. AUD is followed by six simulation questions which test application of the material. BEC’s fourth testlet is a writing sample in which you must complete three short pieces that are scored on both technical content and grammatical structure. FAR and REG both have four testlets as well; however, each of the three first multiple choice sets have 30 questions and the fourth is again a simulation set. AUD and BEC both offer the tester three hours to complete, while FAR and REG offer four hours. Again, outside sources can offer a more detailed explanation of the structure, as this is simply an overview.

When it comes to registering for the CPA exam, you must first have completed the required education for your respective state; details can be found here. For my state (Michigan) and many others, you apply through NASBA. After applying and being approved, you will receive a Notice to Schedule (NTS), this allows you to register with Prometric to take the exam. Remember that testing is only offered in the first two months of each quarter, so plan ahead. I believe a key to success is to register for the exams ahead of time, as doing this adds a level of “stress” to stop the procrastination.

When to take each exam and the amount of time you will need to study for each will vary depending on your situation. For me, I took the exams over the summer of 2013 and in the following order: BEC, FAR, AUD and REG. I planned to spend the summer studying full-time, so this worked out well for me. The one piece of advice I can offer is to take your anticipated “hardest” sections first. When you get to the last exam you are most likely going to be burnt out from CPA exams and your motivation levels will be at all-time lows. Thus, taking your “strongest” sections last will make it that much easier to study. When deciding how much time to dedicate to study, just be honest with yourself. Don’t over plan study time, but don’t short yourself.

When it comes down to study techniques, I recommend using a prep program like Becker. Full disclosure, I am a campus representative for the program and did receive the material at no cost. However, I can confidently say that I believe that they offer the best prep program for the CPA. Regardless of your prep program you use, make sure you first watch or read the lectures then complete as many multiple choice questions as possible. The multiple choice questions are KEY. Most prep programs license their questions for previously used AICPA exam questions, which makes them very relative to the potential exam questions. The more multiple choice questions you complete, the better your retention rate and recall speeds will be on exam day, which is essential to success. I personally completed thousands of questions over the three months I spent studying; but I would like to think that my exam scores reflect this well.

One of the best study habits that I can offer is to set time aside for it. This is imperative to making sure you complete all the necessary preparation prior to exam day. Life offers you a multitude of distractions and more attractive opportunities. You will have to learn to give up your social life for a few months and be willing to turn down the night at the bar in exchange for reviewing IFRS standards. Yes, this will be undesirable, but in the end it will be worth it. As with everything, balance is a necessity, but don’t let this be an excuse to skip on studying in exchange for a few beers or dinner and a movie.

A great way to ensure you stay focused and have the physical and mental energy to get through your day is not only exercise regularly but to also eat healthy. I am neither a dietitian nor a personal trainer, so I will leave the details to the professionals: I will only offer the idea of plentiful cardiovascular exercise combined with a balanced diet. It will be very easy to snack on “junk” all day long while you’re cramming for the CPA, DON’T DO IT!

You will also need the support of your family and friends along the way. If you are in a relationship, prior to starting the exams explain the entire thing to your significant other. Doing this will help him or her better understand not only the importance of this exam, but also the tremendous time dedication it will require. Most people won’t understand how in-depth this exam is and why you can’t socialize more. You can try to explain it to them, but you’ll quickly get sick of this. Accept the fact that they will pressure you and you must be able to say no and ignore their comments and maintain focus. Once you’re done with the exams take them all out to the bar to celebrate and insist on each of them buying you a drink to celebrate, win-win.

For support and focus, I also utilized Another71.com. This site offers a great forum board filled with motivation and support. It is also a great place to either ask or answer questions. During my studying, I would ask questions on topics I did not understand to other members. I also would answer as many questions as I could on material that I understood. Doing this allowed me to reinforce my knowledge and I believe helped improve my performance on the exams.

When prepping for exam day, be ready for stress. The stress level for the first exam will be the worst, as you don’t know exactly what to expect. Don’t worry, they get less and less stressful as you get through them. Make sure you get a good night’s sleep before the exam and stay away from sleep aids as they leave you with “medicine head” the next morning. I am a huge coffee guy and believe that it is necessary for life; however, make sure you know how you react to caffeine prior to taking too much before the exam. You will be stressed as it is, you don’t need a case of the jitters to compliment the stress. Simply put, just relax. If you are prepared, you’ll do fine and there will be no need to worry.

To help alleviate the stress, I recommend packing everything you need in a clear plastic bag the night before. You must have both your state issued ID along with your NTS to get into the testing center. Forgetting either of these will leave you taking the exam at a different time. Weeks prior to exam day, make sure your ID matches your NTS name perfectly, you don’t want any issues on exam day. I am not sure if this applies to all Prometric centers, but mine allowed me to bring snacks in and leave them in the locker. I brought a few power bars to eat in between testlets; remember that these are three and four hour exams and your brain needs power.

I recommend dressing is layers, you will never know how the testing room will be. You will be checked for metal prior to entering the room. Leave hats, belts, watches, rings, etc. at home. Just make sure you are comfortable. I wore athletic shorts, a tee and my Jesus cruiser-style flip-flops to two of my exams. Being comfortable makes the four hours of hell a bit easier to handle.

Have you ever tried to write with a dried up dry-erase marker on a flimsy laminated sheet of graph paper? Well guess what! You will get the opportunity to very soon. Yes, it is as bad as I make it sound, they will give you two markers and I can ensure you that one will be completely dried up and the other will be darn close. Luckily you shouldn't need to write too much down; just be aware of what you will have to use. You can go and get new markers or sheets, but this will consume some of your valuable testing time.

Once you’re in the exam, you will be allowed to leave for breaks between testlets; however, your time does not stop ticking. I do recommend taking breaks between each to stretch your legs and get the blood flowing, and bathroom breaks are great too. Each time you leave, you will need to sign back in using your ID and a finger print, so make sure to factor this time into your plans.

Waiting for your exam score will feel like an eternity, but don’t worry it will come sooner or later. If you have more sections to take, stay focused and keep studying. If you are all done, crack open an ice cold beer and relax. While I am confident that you’ll pass them all on your first attempt if you dedicate the time, if you don’t—just relax. You can retake exams in the next testing window, just make sure you put more time into preparation for the next round. Passing isn't as much a function of smarts as a function of time dedicated to expanding your knowledge.

Best of luck to all you test takers!

Download: Presentation PowerPoint

Financial Statement Flow

Having a strong understanding of the “flow” through financial statements is essential in the valuation process. One must create forecasts and make assumptions that will impact pro-forma financials and should be able to identify how these will flow through the three primary financials. I thought it would be worthwhile to create a post covering the basic flow between each of the primary financials. As with many of my posts, this will have an emphasis on valuation uses and therefore will include certain details that are of particular concern to valuation modeling. Enjoy.

To help guide our conversations, I have created a simple graphic that outlines the most important flows between statements.  I will reference these flows and their colors through the post to help the reader gain a better understanding.

 

Due to the web of flows that is created here, I will start at the top of the income statement and work my way through these in what will hopefully be a coherent manner. Let’s get started.

The income statement starts with revenue less Cost of Goods Sold (COGS) to get gross income and then Sales, General and administrative (SG&A) along with Depreciation and Amortization (D&A) expenses are subtracted to get earnings before interest and tax (EBIT). In some financials D&A in consolidated within SG&A so be on the lookout for this. D&A (purple line) has two primary flows, first of which is to the balance sheet into the Accumulated Depreciation account. The amount of D&A expense will be added to the accumulated depreciation account to calculate Net PP&E. Remember too that only the “D” portion will flow into accumulated depreciation account, not the amortization. If a firm has no intangible assets to amortize, this is easy; however if they consolidate this you might have to dig into the footnotes to determine what amount is actually attributable to depreciation. The second flow for D&A is into the Statement of Cash Flows as an add-back to operating cash flow. Since D&A is a non-cash expense, it must be added back to net income.

Now let’s look at Interest Expense and Income (orange and brown lines). Interest Expense/Income can be found as a line item on historical financials, thus this commentary only applies to forecasting future financials. The general rule of thumb is to calculate interest expense as the average debt—(beginning balance+endining balance)/2—multiplied by the interest expense for the given debt. The same calculation is used for interest income but based on the average cash balance. You can also see the dark orange flow line from payments and issuance of Long-Term Debt (LTD), this will impact the balance and thus the interest expense.

Net Income (NI) is arguable the most important flow to understand. NI is represented by the light-red line and flows into two primary areas. First, NI is used as the starting basis for the indirect cash flow statement creation. The second flow is one that is most often forgotten, NI flows into the Retained Earnings on the balance sheet. Jumping over to the statement of cash flows, we can also see the flow between dividends under the cash flow from financing section to retained earnings (dark red line). Dividends paid will reduce the retained earnings balance while net income will increase it.

Let’s now turn out attention to some balance sheet accounts that have yet to be addressed. The Accounts Receivable (A/R), Inventory, and Accounts Payable (A/P) are all considered working capital (W/C). There may be other items such as accruals, however this is a simplified example. The change in these account balance (light blue) will flow into the statement of cash flows under the cash flow from operations section. I used the term “delta in W/C” to indicate that the change in these could either be an increase in cash flow or a decrease in cash flow. If there is an increase in net working capital (current assets less current liabilities) then this will be a use of cash and therefore a subtraction from net income; the opposite applies if it was a decrease in net working capital. We must also remember that in this instance the net working capital calculation does not include cash.

Next let’s look at the Property, Plant and Equipment (PP&E) account on the balance sheet. We can see the flow between the investing section of the statement of cash flows and the PP&E account on the balance sheet (yellow). If a firm has CapEx it will be an outflow of cash on the statement of cash flow but will be capitalized as an asset and added to PP&E on the balance sheet. Conversely, if a firm sells a piece of equipment it will be a cash inflow on the statement of cash flows while it will reduce the PP&E account on the balance sheet (both the PP&E and accumulated depreciation will be reduced as they relate to the asset being sold).

Lastly, we take a look at the bottom of the statement of cash flows to see that the ending cash balance (green line) will flow back to the balance sheet for the respective period ending. The beginning cash balance comes from the cash balance on the opening balance sheet (not shown in the image).

While this is a very simplified explanation of the flow between the statements, I do hope it puts its all in prospective and helps you better understand the process. Again, I did not list every single flow, only those most important to creating pro-forma forecasted financials. If you have questions or need clarifications, feel free to ask. 

Simple Consolidated Financial Statement Model

 

The consolidated financial statement (CFS) model serves as the basis for creating pro-forma projected financial statements. It also is the foundation to both a discounted cash flow (DCF) and leveraged buyout (LBO) valuation model. These can vary in complexity depending on the needs of the end user and while most contain key elements, the actual design will vary. After a class discussion about CFS in my graduate program, I decided to create a simple example starting with a blank sheet and using the figures from the class as a foundation for model. 

To begin with, I will provide a summary of each seven sections created. Following this, I will offer some advice for creating models such as these, including errors to watch out for. Lastly, a short list of design features and their basic explanations has been included to assist the user in their understanding of the model.

The Seven Sections

Within this consolidated financial statement model, I have included seven sections. These include not only the three primary financial statements, but also supporting schedules. The first statement is a key ratio summary for the entire model. This was included as the first section to allow the user to quickly review the financial health of the firm over the modeled period.

The next section is the consolidated income statement. This section creates a pro-forma income statement that includes two historical years and seven projected years. The total revenue is forecasted based on an annual expected growth rate and COGS is based on a percentage of sales remaining constant from 2015E through 2021E. R&D and SG&A expense are calculated as a percentage of sales with independent calculations for each year. The tax rate is entered in the left side of the tax column; however, there is an annual tax override line which allows users to change the effective tax rate for any year. In the absence of this metric, the model uses the stated rate from the left column. Dividends are calculated on an annual per share basis and shares outstanding are expected to remain constant from 2013A.

The balance sheet is very standard with inputs feeding in from other supporting sections and does not warrant any detailed explanation. One noteworthy area is the inflow from the working capital section into the current assets and current liability section. Also the short-term and long-term debt flows in from the debt schedule. The cash flow statement is very much the same. The primary details that should be noted is the inflow from the debt schedule for the financing section of cash flow statement along with the inflow of CapEx from the deprecation schedule.

The Working capital schedule outlines the expected days sales outstanding (DSO), inventory turnover days and days payables outstanding (DPO) for each of the forecasted periods. From these metrics, the forecasted account balances can be calculated. The change in net working capital then flows back into the cash flow statement under changes in cash flow from operations.

The depreciation schedule begin with the forecasted CapEx for each period along with the expected useful life of the asset. The first portion of the schedule calculated book depreciation based on straight-line over the asset’s respective useful life and assumes zero salvage value. The second portion gives the accelerated deprecation values for each asset of each period. These are fictitious number created for illustrative purposes only, but would be representative of accelerated deprecation offered under tax purposes. The third portion computes the depreciation under the accelerated tax method for each respective period. Finally the difference is calculated. The tax rate is fed in from the income statement to calculate the deferred taxes. These are then fed into the balance sheet for either a deferred tax asset or liability.

Lastly the debt schedule. This section begin with the cash at the beginning of the year and then adds cash inflow available for debt repayment from the cash flow statement. There is a line item for the desired minimum cash, which is assumed to remain constant through the entire period; the end of this portion shows the excess cash available for debt repayment. For both the short-term and long-term debt portions the beginning balance is shown first.

Next the mandatory payment and optional payment is calculated. The mandatory payment is expected to remain constant through the model. The option payment is the maximum possible while still maintaining the minimum cash balance. In the event that the firm has less than the desired minimum cash balance, the additional cash is drawn from debt. The short-term debt is either paid or draw from first then any remaining transaction occurs in the long-term debt. The short-term debt also has a celling figure that limits the maximum draw on the credit line. For both the short-term debt and the long-term debt, there is a toggle figure for additional payments/draws; 0 = no additional, 1 = additional.

Interest expense for both short-term and long-term debt is calculated based on average balance based on the interested rate entered in the left column for each respectively. Lastly, the cash balance at the end of the year is calculated and interest income is calculated based on average cash balance. All of these figures flow back into the income statement, balance sheet and statement of cash flows.

Errors to Watch Out For

If you have ever created a financial model from scratch you know there are many little nuances that you must be on the look-out for. While I will not name all of these, I would like to point out a few that are key to success. First and foremost, you balance sheet must BALANCE! This can be a daunting task, but make sure it balances with primarily all formula driven figures (ie: do not go and change a number to “make it work”). Be very careful in your cash flows and debt schedule. These two are very interrelated and you must have them feeding from each other properly or you will never have a functional model. While I am not going to outline the exact process I used for this, I can recommend that you follow my formulas and see how the model is calculating. Lastly, use formula in every place possible. The more formula driven figures the easier it is to ensure a properly functioning model.

Key Feature of the Model

Just a few features to point out. I have created the entire model in a single sheet and used grouping to allow the user to collapse/expand the sections for ease of viewing. Having the entire model in a single sheet makes it significantly easier to both audit and write your formulas. If at all possible, I recommend keeping your model to a single sheet.

There is an “ERROR” checker embedded in the heading of each section. In the upper right hand corner is a formula that looks to see if the balance sheet balances for every period in the model. If it doesn’t, “ERROR” will appear in red font. In doing this, it will allow the user to be well aware of issues in the before making a decision using the model.

The date is entered for the first actual period under the “Key Financial Ratios” section and the next either period’s dates are calculated based on end of 12 months forward. The rest of the dates in the entire sheet are fed from this first set of inputs. This will ensure uniformity within the model.

Some formatting issues. Color coding is essential. Black font represents text or formula driven cells while blue font indicates a user input. This allows the user to easily distinguish between these two. Also, the only cell that was merged was the top heading, all other cells were simply centered. The cell width and height was left the same for each cell in the model, this is great for uniformity. Sum bars were used to indicate sums and a thick black boarder is at the bottom of each section. After the model was completed, the cell outlines were removed. Doing these simple formatting processes can really make your model look great and provide ease of use.

I hope you enjoyed this short narrative of my consolidate financial model. A link to this model can be found at the bottom of this post and under the Excel Files section of my blog. 

Simple CFS Model

Simple Deferred Tax Asset & Liability Explanation

If you have ever taken a look at the balance sheet of almost any publicly traded firm, you will probably notice either a deferred tax asset or a deferred tax liability. While these are relatively simple to understand, I wanted to take a few moments to talk about how these are created and how they will impact not only the GAAP financials, but also the valuation process.

To begin with, what is a deferred tax account? In the U.S. all public companies are required to follow U.S. Generally Accepted Accounting Principles (GAAP) for financial reporting. However, for tax purposes, they follow a slightly different system of accounting. The difference in treatment for certain items can leave a firm actually having different amount of taxable income for accounting books purposes than for tax. Some of these differences are permeate other are simply temporary. Let’s discuss the differences and see some examples.

Permanent Differences

Certain expense are never taxable or are never tax deductible under U.S. Tax law. Take for example the investment in a municipal bond; the coupon stream for muni bonds is never taxable at the Federal level. If a firm is invested in a muni bond, they will show a higher book income versus a taxable income. Now let’s look at a federal fine for pollution. While the firm will use this as an expense for accounting purposes (hopefully extraordinary) they are not allowed to write it off on their tax income and therefore will have a higher tax income than book income. Since issues like these are never reversed, the income tax expense associated with these is factored in on the tax expense for the respective period.

Temporary Differences

While permanent differences are relatively simply and straight forward, temporary differences can be much trickier. Take for example the differences in depreciation methods. Most firms will choose to depreciate an asset under the straight line method, however under U.S. Tax law a system of depreciation called MACRS is used. This is essentially and accelerated deprecation system. This will generally cause the firm to have higher book taxable income in the early years and lower book taxable income in the later years versus the tax accounting income.

If a firm has a book taxable income of $1,000 but a tax accounting taxable income of $800 with a 40% tax rate what will they expense and what will they pay? For accounting purposes they will have income tax expense of $400; however, they will actually only have a tax liability of $320. Now since the difference is temporary and will reverse at a later time, they must account for this. To do this they will create an account-either an asset or a liability. From a valuation stand point, we must remember that the cash flows will be effected due to the differences between actual tax expense and tax liabilities paid in cash.

Since I think some of this can be a bit hard to explain in writing, I have decided to create a short screen cast. I hope this helps make this issue a bit clear.

I do understand that this is not an extensive explanation of deferred tax assets or liability, but I do hope it lays the foundation for a better understanding. 

Excel Model: Defered Taxes & Valuation Example

Leases and Their Role in Valuation

A lease is a contractual agreement in which one party (the lessor) agrees to allow another party (the lessee) use an asset for a stated period of time. In return, the lessee agrees to make fixed cash payments to the lessor. Since the title does not transfer to the lessee, this is not considered a sale and thus the asset is not recorded on the books of the lessee, rather it stays on the books of the lessor. While this makes sense, there is a problem. Leases are allowing a firm to obtain an asset in return for a future commitment of payments, this is essentially adding an asset to the firm and a corresponding liability. When a firm accounts for this transaction as a lease rather than a sale, it is essentially able to avoid putting the liability on their balance sheet; this is often referred to as “off-balance sheet financing”. This can lead to investors underestimating the liabilities a firm has and therefore poses a risk to the investing community.

Enter capital leases. Under U.S. GAAP, two forms of leasing exist. The first is an operating lease and the second being a capital lease; with the former reflecting the above discussion. Capital leases on the other hand are required to be accounting for in a different manner in which the asset and corresponding liability are reflected on the lessee’s balance sheet. A lease will be classified as a capital lease if it satisfies any one of the following requirements.

1. The life of the lease exceeds 75% of the economic life of the asset.
   (Lease a truck for 9 years that has a useful life of 10 years)
     
2. The present value all future lease commitments is greater than 90% of the current fair market value of the asset.
   (The PV of lease payments is $1,000, when the FMV of the asset is $850)  
   
   
3. The title of the asset transfers from the lessor to the lessee at the conclusion of the lease.
   (After 10 years of leasing a computer, the title of ownership transfers to the lessee) 
         
4. There is bargain purchase price option included in the lease.
   (At the end of a machinery lease, the lessee can purchase the asset for $100, despite the FMV at that time being significantly higher)

In essence, a lease that meets any of the criteria above--while not meeting the legal requirements of a sale--is an economic sale. Since this is the case, the asset being leased is removed from the books of the lessor and placed on the books of the lessee. In addition, the present value of all lease payments are considered a liability on the lessee’s balance sheet and an asset on the lessor’s. This does have a valid reasoning since these type of leases are essentially a form of capital financing and thus should be included in the liabilities section of the balance sheet. Rather than the lessee considering the payment to the lessor an expense, it is now an amortization of the liability with the difference between the payment and the amortized amount classified as interest expense (another indication of debt financing). In addition, the lessee can now depreciate the asset over its useful life.

While much more could be said about capital lease (a possible future topic), I believe from a valuation stand point it is relatively clear as to the treatment. Since they are already classified as assets and a corresponding liability, not too much more needs deep consideration. However, I do not feel the same for operating leases.

If a lease agreement does not meet any of the four criteria outlined above, it will be considered an operating lease. Under this treatment, the lessee does not record the asset nor the corresponding liability. The payments are simply considered lease expense. This is a preference for many firms, as it will give the appearance of a stronger balance sheet (lower debt); thus, it is common for firms to attempt to structure leases in a manner that will allow operating lease treatment under U.S. GAAP. One of the most common assets to be classified as operating leases, while taking on more of an appearance as capital financing, is retail real estate. Since the economic life can be very long for a retail location and the lessor generally has no interest in transferring title at the end of the lease, it is relatively easy to structure a deal in such a way that it will be classified as an operating lease.

With the above said, think about industries such appear retailers and restaurants. In these industries, many operating leases are created for the real estate being used in the ordinary course of business. While these leases are structured in such a way that they are treated as operating leases, they do constitute a large portion of the operating expenses and, in my opinion, represent a form of debt financing. I say this due to the fact that they allow the firm the use of an asset in return for a requirement of a fixed payment; sounds a whole lot like debt financing to me.  

From my perspective, it would be necessary to take the expected future payments of these leases (in many cases this figure can be found on the firm’s 10-K) and discount them to their present value and capitalize them, adding both an asset and liability to the pro-forma statements. The discount factor should be the firm’s pre-tax cost of debt for the firm (pre-tax since the payment being discounted is a pre-tax item). In addition, these payments should no longer be treated as lease expense, but as interest expense. The net effect of this process would be an increase to EBIT, EBITDA, and the weight of debt in the WACC calculation.

Since the EBIT, EBITDA and WACC all play a very important role in a DCF valuation, this process can be key to an accurate calculation in some cases. Is this always right? As with most valuation topics, there can be a long debate about how valid this theory is. However, I do believe that in certain industries that rely heavily on operating leases, not creating pro-forma financials with these operating leases capitalized will create an error in your final valuation.

As a last note, while I believe this process to be an accurate treatment for many operating leases, in cases where the operating leases do not represent a major portion of the firm’s expenses, I do not believe this process will yield a material difference the final valuation.