The pretax cash flow is the same: you make the same lease payments whether you’re treating it as an operating lease or a finance lease. So the only difference in cash flow has to come from the income taxes you pay.
In the early years, depreciation exceeds principle. So, in the early years, the expenses under a finance lease exceed the expenses under an operating lease. Thus, in the early years, taxable income under a finance lease is lower than taxable income under an operating lease. Therefore, in the early years, income taxes are lower under a finance lease are lower than income taxes under an operating lease: after tax cash flow is higher under a finance lease.
In the late years, all of this reverses.
Thanks S2000magician for your response.
I think I am getting it. Do you think there is a difference between an expense on cash flow statement, which I believe is equal to Payment + Tax expense, and expense on Income statement, which I believe is equal to Dep + Interest (Finance / Capital Lease) or equal to Payment (Operating Lease). Do you think my understanding is correct? I would really appreciate your help.
Thanks in advance.
Part of the difficulty you’re having may stem from using incorrect terminology (which can lead to incorrect thinking/analysis).
The statement of cash flows does not have expenses (or revenues, for that matter): it has cash outflows and cash inflows. The income statement has expenses (and, of course, revenues) which may or may not be based on cash.
So, when you lease a machine, you have lease payments: cash outflows. You may classify the lease as an operating lease, in which case the rent expense (income statement) is the same as the lease payment (cash flow statement).
You may classify the lease as a finance lease, in which case the expense (interest (cash) and depreciation (non-cash), income statement) is different from the lease payment (interest and principle, cash flow statement).
If there were no income taxes, the cash flow would be the same under both classifications: the cash outflow will be the lease payments. When there are income taxes, the cash flow will be different, because the amount of income tax will depend on the amount of expenses: higher expenses give lower taxable income, so lower taxes to pay. In the early years, the expenses under a finance lease (interest plus depreciation) will be higher than the expenses under an operating lease (rent), so taxable income will be lower under a finance lease than under an operating lease, so income taxes (cash outflow) will be lower under a finance lease than under an operating lease. A lower cash outflow means that (positive) cash flow will be higher under a finance lease than under an operating lease.
For the entire period of the lease, expenses under an operating lease will be exactly the same as expenses under a finance lease. Because expenses under a finance lease are higher than under an operating lease in the early years, they have to be lower in the later years.
Perfect! Thank you so much, S2000magician. I would have visited these posts gazillion number of times to understand this. Finally, it’s clear. You are a genius. Thank you so much!
Best regards
You’re quite welcome. Glad I finally hit the magic words.