Are operating leases debt?

To a lender, a lease the business cannot cancel is a fixed obligation it must meet before it meets the bank, which is what debt is. The accounting treatment has changed — the international standard in force since 2019 puts most leases on the balance sheet as a liability and a right-of-use asset — but lenders adjusted for leases long before the standard did, and still do for accounts prepared under simpler frameworks that leave them off. The risk did not change in 2019; its visibility did.

What is fixed charge cover, and why read it beside leverage?

Fixed charge cover puts the rent on both sides of a cover ratio: earnings before rent and interest, divided by rent plus interest plus scheduled principal. It answers the question leverage only hints at — can the business pay everyone it has no choice about paying, out of this year's cash — and it is the ratio that catches a retailer whose leverage looks modest because its obligations are rent rather than loans.

Why do loan covenants freeze the accounting standard?

Because a covenant set at 2.5 times on the old treatment would be breached by the new one on the day the standard changed, with nothing in the business having moved. Facility agreements therefore often define EBITDA and debt as they were under the standards in force when the agreement was signed, and the compliance certificate restates the accounts to that definition. A reader of the covenant has to know which treatment it is written in, and a reader of the accounts has to know the covenant may not match them.

Does putting leases on the balance sheet change the risk?

No. A retailer with fourteen leased stores owes fourteen landlords the same rent whether or not the liability is printed. What changes is what a reader can see without working: before, the obligation lived in a note and a rent line; after, it stands in the debt. A lender's adjustment exists so that the reading does not depend on the printing.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Lease-Adjusted Leverage: a Worked Example

Put the leases on both sides, and the multiple doubles.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-10-11

// THE SHORT ANSWER

Lease-adjusted leverage is net debt to EBITDA with a business's leases treated as the borrowing they are: the capitalised lease liability joins net debt, and the rent that was inside operating costs comes back into EBITDA. A retailer with US$6m of net debt and US$4m of EBITDA reports 1.5 times; with US$15m of lease liabilities and US$3m of rent it is 3.0 times on the same business. Lenders have made the adjustment for years, whatever the accounting standard of the day did, because a lease that cannot be cancelled is a fixed charge the business must pay before it pays the bank.

BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.

// MAKE THE CALL

Issue 06 — Kowhai Retail Group. Last Christmas didn't clear. This year's buy is up 22%. The seasonal uplift request is in. Your call first, then the senior banker's.

Read the file →

// 01 — WHY A LEASE IS DEBT TO A LENDER

A business that leases its premises has promised a landlord a fixed sum every month for years, and cannot stop paying without closing the store. That promise ranks ahead of the bank in every practical sense: the rent is paid before the interest, and a landlord who is not paid changes the locks. A lender therefore reads a lease as borrowing with a different creditor, and adjusts the leverage ratio so that two businesses with the same obligations look the same whether one owns its stores and borrowed to buy them or the other rents them.

Lease-adjusted net debt = net debt + capitalised lease liability

Lease-adjusted EBITDA = EBITDA + rent (the rent comes out of costs)

Leverage = adjusted net debt ÷ adjusted EBITDA

Both sides move. The liability joins the debt; the rent, which was inside operating costs, comes back into earnings, because it is now being treated as the servicing of that debt. Adjust one side without the other and the ratio is wrong in a different way, as the example shows.

// 02 — THE EXAMPLE

A retailer — constructed for this page, like every figure on this site — reports net debt of US$6m and EBITDA of US$4m in accounts that keep its store leases off the balance sheet. Its leases, capitalised, would be a liability of US$15m; the annual rent inside its operating costs is US$3m.

As reported: 6 ÷ 4 = 1.5×

Lease-adjusted: (6 + 15) ÷ (4 + 3) = 21 ÷ 7 = 3.0×

The half-adjustment: (6 + 15) ÷ 4 = 5.3× ← debt adjusted, earnings not

The business has not changed between the first line and the second. What has changed is that the reader can now see the fourteen landlords. At 3.0 times it is a moderately geared retailer; at 1.5 it looked like a business with almost no debt, which it never was. The third line is the mistake a reader makes when the liability is added and the rent forgotten: a number that frightens for the wrong reason.

// 03 — THE RATIO A LENDER READS BESIDE IT

Leverage says how much is owed against what is earned. It does not say whether this year's cash can pay everyone the business has no choice about paying. That is fixed charge cover, and for a business whose obligations are mostly rent it is the ratio that matters:

Fixed charge cover = (EBITDA + rent) ÷ (rent + interest + scheduled principal)

On the example, with interest of US$0.5m and principal of US$0.5m:

(4 + 3) ÷ (3 + 0.5 + 0.5) = 7 ÷ 4 = 1.75×

The business earns 1.75 times what it must pay out whatever happens to sales. A lender tests that cover at a lower level of sales, because the rent does not fall when the sales do — the reading behind a seasonal retailer's file like Issue 06, and behind the covenant that protected a listed retailer's lenders in Issue 07, where every store is leased.

WORK IT · THE NUMBER → · LEASE CAPITALISATION, THE FIRST QUESTION → · FIXED CHARGE COVER, DEFINED →

// 04 — WHERE IT DECIDES A FILE

Issue 06 is a fourteen-store retailer asking for a bigger seasonal line, and the stores are leased; Issue 07 is a listed retailer whose every store is leased and whose covenants are measured on reported EBITDA. In both, the rent is the obligation the headline leverage does not show, and the covenant definitions decide which version of the business the bank is testing.

ISSUE 06 · THE SEASONAL LINE → · ISSUE 07 · QUALITY OF EARNINGS → · DEBT TO EBITDA →

// STANDARDS THIS SITS BESIDE

The recognised ground this page sits beside. Each was opened and checked when cited; none is a source for the framework itself.

IFRS Foundation, IFRS 16 Leases — overview of the standard — A lessee recognises a right-of-use asset and a lease liability for every lease longer than 12 months unless the asset is of low value — the lease as debt in section 01.
International Accounting Standards Board, IFRS 16 Leases — Effects Analysis (January 2016) — Without lease obligations on the balance sheet, investors and analysts could not properly compare companies that borrow to buy assets with those that lease them without making adjustments — the adjustment worked in section 02.

// QUESTIONS PEOPLE ASK

Are operating leases debt?: To a lender, a lease the business cannot cancel is a fixed obligation it must meet before it meets the bank, which is what debt is. The accounting treatment has changed — the international standard in force since 2019 puts most leases on the balance sheet as a liability and a right-of-use asset — but lenders adjusted for leases long before the standard did, and still do for accounts prepared under simpler frameworks that leave them off. The risk did not change in 2019; its visibility did.
What is fixed charge cover, and why read it beside leverage?: Fixed charge cover puts the rent on both sides of a cover ratio: earnings before rent and interest, divided by rent plus interest plus scheduled principal. It answers the question leverage only hints at — can the business pay everyone it has no choice about paying, out of this year's cash — and it is the ratio that catches a retailer whose leverage looks modest because its obligations are rent rather than loans.
Why do loan covenants freeze the accounting standard?: Because a covenant set at 2.5 times on the old treatment would be breached by the new one on the day the standard changed, with nothing in the business having moved. Facility agreements therefore often define EBITDA and debt as they were under the standards in force when the agreement was signed, and the compliance certificate restates the accounts to that definition. A reader of the covenant has to know which treatment it is written in, and a reader of the accounts has to know the covenant may not match them.
Does putting leases on the balance sheet change the risk?: No. A retailer with fourteen leased stores owes fourteen landlords the same rent whether or not the liability is printed. What changes is what a reader can see without working: before, the obligation lived in a note and a rent line; after, it stands in the debt. A lender's adjustment exists so that the reading does not depend on the printing.

THE IN-TRAY · ONE MINUTE

Make the call on one file.

A short file on the ground this page covers. Every option opens with how far it sits from a senior banker’s read.

THE NUMBER · THE BORROWER · BALANCE SHEET

A retailer's accounts keep its store leases off the balance sheet. Its banker restates them as if the leases were capitalised.

Net debt, as reported: US$6m
EBITDA, as reported: US$4m
Lease liability if capitalised: US$15m
Annual rent inside operating costs: US$3m

What is net debt to EBITDA with the leases on the balance sheet?

6 MORE ON THE BORROWER · BALANCE SHEET →WHERE DO YOU READ FROM? THE PLACEMENT →