The same transaction raises or lowers return on capital employed depending on how the lease is counted, and the building's book value drives most of the answer.
It depends on which ROCE you mean, and on the book value of the building more than on the deal. In an illustrative company earning an EBIT of 30.0 on 200.0 of capital employed, selling a property held at 60.0 for 100.0 and leasing it back at 6.5 per cent lifts ROCE from 15.00 to 16.01 per cent under IFRS 16, and to 17.50 per cent if the rent is simply expensed. Capitalise the rent at a multiple, the traditional credit-analyst adjustment, and ROCE falls to 13.89 per cent.
Worked in full in Sale and Leaseback by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Return on capital employed is EBIT divided by the capital that produces it, usually measured as equity plus net debt. A sale and leaseback changes both halves. EBIT loses the building's depreciation and takes on a cost for the lease. Capital employed loses the building at its book value, gains the cash, and, depending on the accounting, gains a right-of-use asset and a lease liability. Each of the three common definitions treats the lease differently, so the same transaction can be presented as an improvement or a deterioration. A finance director should know all three before the board pack does.
| Input | Value |
|---|---|
| Operating assets other than the property | 140.0 |
| Property at book value (land and building) | 60.0 |
| Annual depreciation of the building | 1.0 |
| EBIT before the transaction | 30.0 |
| Net debt / equity before | 80.0 / 120.0 |
| Sale price, at fair value | 100.0 |
| Leaseback rent / yield on price | 6.50 / 6.50% |
| Lease term / incremental borrowing rate | 15 years / 6.0% |
Before the transaction ROCE is 30.0 ÷ 200.0 = 15.00 per cent. The 100.0 of proceeds repays all 80.0 of net debt and leaves 20.0 of cash.
This is the pre-IFRS 16 view, still common in management reporting and frozen-GAAP covenants: the building leaves, the rent becomes an operating cost.
EBIT after = 30.0 + 1.0 depreciation saved − 6.50 rent = 24.50
Capital employed after = 140.0 other assets (equity 160.00 including the full 40.00 gain, net cash 20.00)
ROCE = 24.50 ÷ 140.0 = 17.50%
EBIT falls by 5.50 a year, which is a 9.17 per cent return on the 60.0 of book value that left the balance sheet. Because 9.17 per cent is below the company's 15.00 per cent, removing that capital raises the average. Measured on the 100.0 price, the same 5.50 is only 5.50 per cent, and that comparison is the economically meaningful one.
Under IFRS 16 the seller keeps a right-of-use asset equal to the share of the old carrying amount that relates to the right it retains, and recognises a lease liability at the present value of the rent. Only the part of the gain relating to the rights transferred to the buyer is booked.
Lease liability = 6.50 × annuity factor (6.0%, 15 years) = 6.50 × 9.7122 = 63.13
Right-of-use asset = 60.0 × 63.13 ÷ 100.0 = 37.88
Gain recognised = 40.00 × (100.0 − 63.13) ÷ 100.0 = 14.75
EBIT after = 30.0 + 1.0 − 37.88 ÷ 15 = 30.0 + 1.0 − 2.53 = 28.47
Capital employed after = 140.0 + 37.88 = 177.88 (equity 134.75, net debt including the lease 43.13)
ROCE = 28.47 ÷ 177.88 = 16.01%
Excel: =PV(6%,15,-6.5) returns 63.13
The rent no longer passes through EBIT. Its 3.79 of first-year interest sits below the line, and only the 2.53 of right-of-use depreciation is charged above it. That is why IFRS 16 EBIT is 3.97 higher than the rent-expensed figure, while capital employed is also higher by the right-of-use asset. The two effects net to an improvement of 1.01 points instead of 2.50.
Before IFRS 16, credit analysts commonly restated a lease as debt by capitalising the rent at a multiple, traditionally 8 times, and adding back an implied interest share of the rent, here one third. Some investors still use this shortcut. On that basis the lease brings 52.00 of capital back in:
EBIT adjusted = 24.50 + 6.50 ÷ 3 = 26.67
Capital employed adjusted = 140.0 + 8 × 6.50 = 192.00
ROCE = 26.67 ÷ 192.00 = 13.89%
The company is shown as less productive, because the capitalised lease has replaced a property that was carried at a depreciated 60.0 with a claim measured on a current rent.
| Yield | Rent | Lease liability | IFRS 16 | Rent expensed | Lease-adjusted |
|---|---|---|---|---|---|
| 5.50% | 5.50 | 53.42 | 16.78% | 18.21% | 14.86% |
| 6.50% | 6.50 | 63.13 | 16.01% | 17.50% | 13.89% |
| 7.50% | 7.50 | 72.84 | 15.29% | 16.79% | 13.00% |
| 9.00% | 9.00 | 87.41 | 14.29% | 15.71% | 11.79% |
ROCE stops improving at a yield of 10.00 per cent on the rent-expensed basis, 7.92 per cent under IFRS 16 and 5.36 per cent lease-adjusted. Those break-evens are far apart, which is the point: the yield a board can accept depends on which ratio the covenant, the bonus plan or the analyst uses.
| Book value | ROCE before | IFRS 16 after | Rent expensed after | Gain recognised (IFRS 16) |
|---|---|---|---|---|
| 30.0 | 17.65% | 18.71% | 17.50% | 25.81 |
| 60.0 | 15.00% | 16.01% | 17.50% | 14.75 |
| 90.0 | 13.04% | 13.83% | 17.50% | 3.69 |
On the rent-expensed basis the result after the sale is 17.50 per cent whatever the book value, because the building is gone. The change is therefore entirely a function of the starting ratio, and a low book value flatters that starting ratio. A company with a heavily depreciated head office at 30.0 sees ROCE fall on this basis, from 17.65 to 17.50 per cent, on exactly the same transaction, because the 5.50 of EBIT given up is an 18.33 per cent return on the 30.0 of capital removed. Under IFRS 16 the effect runs the other way and is small: the improvement is 1.06 points at a book value of 30.0 and 0.78 points at 90.0.
Booking the gain in operating profit and quoting the year-one ROCE. Under IFRS 16 the 14.75 recognised gain, if presented within EBIT, lifts the year-one ratio to 24.30 per cent, a figure that will never recur. The second mistake is reading any improvement as value created. ROCE rises here because the 5.50 of EBIT given up is only 9.17 per cent of the 60.0 of book capital removed, below the 15.00 per cent average; the company has not become more productive. Whether the leaseback creates value is a cost of capital question: a 6.50 per cent rent for 15 years against the company's own borrowing cost, which is what the comparison with a mortgage on the same building answers.
Illustrative and pre-tax. Year-one figures; under IFRS 16 the right-of-use asset and the liability then amortise at different speeds, so the ratio drifts over the lease. The sale is assumed to qualify as a sale under IFRS 15, at fair value.
A sale and leaseback improves ROCE on the two accounting bases when the EBIT given up, measured on the book capital released, earns less than the company's existing ROCE, here by 1.01 points under IFRS 16 and 2.50 points with the rent expensed. A heavily depreciated building can turn the rent-expensed result into a fall. On a lease-adjusted basis it lowers ROCE to 13.89 per cent. Present all three, and the IFRS 16 gain outside EBIT. The book works the transaction from rent cover, over-rent and covenant risk, and the free workbooks for the book carry the seller's IFRS 16 arithmetic. The gain itself is worked in how to calculate the gain on a sale and leaseback under IFRS 16.
Because the seller keeps a right-of-use asset, 37.88 in the worked case, so capital employed only falls from 200.0 to 177.88 rather than to 140.0. EBIT is higher, 28.47 against 24.50, because only the 2.53 of right-of-use depreciation is charged above the line and the 3.79 of lease interest sits below it. Net, ROCE rises 1.01 points instead of 2.50.
In the worked case at 10.00 per cent with the rent expensed, 7.92 per cent under IFRS 16 and 5.36 per cent on a lease-adjusted basis with the rent capitalised at 8 times. The spread between those break-evens is why a board should agree which definition matters before negotiating the rent.
Not in a ratio used to judge operating performance. The 14.75 gain recognised under IFRS 16 in the worked case would lift year-one ROCE to 24.30 per cent if it were presented within EBIT, a level that never recurs. Show it separately and quote ROCE on recurring EBIT of 28.47.
This article is one calculation from Sale and Leaseback. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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