Can anyone explain me why the CFO is higher with Finance lease as compared to Operating Lease with example.
Pretax cash flows are the same.
Because early year expenses are higher for finance leases than for operating leases, taxable income will be lower, so income taxes will be lower, leading to higher (after-tax) CFO. In later years this is reversed; if tax rates remain constant, ultimately total CFO will be the same.
Thank u S2000magician.
Now I have understood the concept.
You’re welcome.
I’m glad to hear it.
As a lessee and under financial lease,
You increase both your asset and non-current liability by PV of lease pmts owed (under asset and lease payable).
Your cash pmt is divided into 2 part, interest expense (as CFO) and reduction of your liabilibity (as CFF). So CFO under finance lease is ALWAYS higher than CFO under operating lease throughout the lease because your entire pmt is charged to CFO outflow under operating lease.
However, the TOTAL CF will be the same under 2 different leases.
Also note that on your income statement, you incur 2 charges, depreciation (operating expense) and interest expense (non-operating expense). Therefore, your NI is LOWER and your operating income is HIGHER in the first few years under finance lease while eventually both NI and operating income become higher in the later years as interest expense decreases.
As a lessor and under finance lease
You remove the asset and add lease receivable (= PV of lease pmts)
Every year when you receive your lease pmt, it is broken down into CFO (interest income) and CFI (reduction in your account receivable. So your CFO is LOWER and CFI is HIGHER under finance lease throught out the entire lease ( TOTAL CF is the same under both leases).
On income statement, you incur interest income and NI is higher because interest income is higher during the first few years (due to higher acct receivable) where as under operating lease your income is the difference between the lease pmt & depreciation.
Thanks a lot cgy5478
To be clear, total cash flow _ over the entire life of the lease _ is the same, and _ total pretax cash flow each year _ is the same, but _ total after-tax cash flow each year _ will differ.