A:

Bond covenants can limit the amount of leases a company can have because leasing contracts are a form of debt. Taking on more debt is a form of risk in the eyes of the bondholders, and therefore bond covenants typically restrict the amount of debt a company can take on. This restriction can sometimes come in the form of a maximum debt-to-equity ratio that the company is not allowed to surpass. If the company's debt-to-equity ratio exceeds the agreed-upon level this could constitute a breach of the contract and the bondholder has the right to seek legal remedy.

Occasionally, companies may try to hide leases off their balance sheet by claiming them as operating leases instead of capital leases, which allows them to circumvent bond ratio covenants. The lease would be treated as a capital lease if one of the following criteria is met: there is a transfer of ownership; there is a bargain purchase option in the lease; the lease life is more than 75% of the economic life of the asset; or the present value of the lease payments are more than 90% of its cost. To avoid treating the lease as a capital lease, the company may structure the lease so that it does not technically qualify as a capital lease by adjusting the lease life, lease payments or other aspects of the lease. Of course, bondholders are aware of this and often have covenants that will take into account off-balance sheet leases.

Learn more about off balance sheet debt in our article: Uncovering Hidden Debt.

This FAQ was answered by Joe Nguyen.

RELATED FAQS
  1. How have low interest rates affected lease rates in the automotive sector?

    Find out how and why lower interest rates for leasing new automobiles have helped spur more consumers to lease cars instead ... Read Answer >>
  2. What are the differences between single, double and triple-net leases?

    Learn the ins and outs of net lease agreements, including the key differences between single net, double net and triple net ... Read Answer >>
  3. What kinds of real estate transactions use triple net (NNN) leases?

    Learn how a net-net-net or triple net lease works and why it is popular in commercial real estate transactions. It is also ... Read Answer >>
  4. How does the value of the real estate impact the value of a triple net (NNN) lease?

    Understand how the value of the real estate involved in a triple-net lease impacts the value of the lease both positively ... Read Answer >>
Related Articles
  1. Investing

    How Does an Operating Lease Work?

    Operating lease is a term used mostly in accounting to denote a lease that gives the lessee rights to use and operate an asset without ownership.
  2. Managing Wealth

    What is a Capital Lease?

    A lease considered to have the economic characteristics of asset ownership.
  3. Investing

    Uncovering Hidden Debt

    Understand how financing through operating leases, synthetic leases, and securitizations affects companies' image of performance.
  4. Personal Finance

    Is There a Way to Get Out of Your Car Lease Early?

    For those who no longer want their car for whatever reason, transferring the lease to an interested party can be a particularly appealing choice.
  5. Personal Finance

    When Is Buying A Car Better Than Leasing?

    People who lease a car are often more concerned with the short-term picture.
  6. Retirement

    Retirees: Should You Buy or Lease Your Car?

    To buy or lease – that is the question. For retirees, access to safer cars, comprehensive warranties and tax deductions may drive up leasing's appeal.
  7. Managing Wealth

    Why You Should Buy A Car Instead Of Leasing

    While leasing has certain advantages, buying a car tends to save you money in the long run and offers greater flexibility.
  8. Investing

    New Wheels: Lease Or Buy?

    These two major ways to obtain a car have very different advantages and drawbacks. Find out which is best for you.
  9. Managing Wealth

    4 Ways to Get the Best Deal on a Car Lease

    Car buyers typically negotiate when purchasing a vehicle, but many don't negotiate when leasing a car. There are several ways to save if you ask.
  10. Managing Wealth

    Your Lease Is Up: When Should You Buy The Car?

    In general, the fact that you know the car is to your benefit. Before deciding, compare the buyback price to what the car would go for on the open market.
RELATED TERMS
  1. Capitalized Lease Method

    An accounting approach that identifies a company's lease obligation ...
  2. Operating Lease

    A contract that allows for the use of an asset, but does not ...
  3. Capital Lease

    A lease considered to have the economic characteristics of asset ...
  4. Leasehold

    An accounting term used to classify an asset on a company's balance ...
  5. Lease Utilization

    A financial ratio that measures how much a company uses leasing ...
  6. Bargain Renewal Option

    A clause in a lease agreement that gives the lessee the option ...
Hot Definitions
  1. Book Value

    1. The value at which an asset is carried on a balance sheet. To calculate, take the cost of an asset minus the accumulated ...
  2. Dividend Yield

    A financial ratio that shows how much a company pays out in dividends each year relative to its share price.
  3. Fixed-Income Security

    An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. ...
  4. Free Cash Flow - FCF

    A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents ...
  5. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to ...
  6. Two And Twenty

    A type of compensation structure that hedge fund managers typically employ in which part of compensation is performance based. ...
Trading Center