Many companies use long-term leases to finance long-term assets. Although these leases are similar to mortgage payments, they are structured in such a way that they qualify as operating leases. As a result, the lease commitments do not appear on the companies’ balance sheets.
In a recent year, Continental Airlines had almost $15 billion in total operating lease commitments, of which $1.5 billion was due in the current year. Further, the airline had total assets of $12.686 billion and total liabilities of $12.581 billion. Because of heavy losses in previous years, its stockholders’ equity was only $0.105 billion.
What effect do these types of leases have on the balance sheet? Why would the use of these long-term leases make a company’s debt to equity ratio, interest coverage ratio, and free cash flow look better than they really are? What is a capital lease? How does the application of capital lease accounting provide insight into a company’s financial health?