4.3 Growth and Assets Acquisition

We have noted that, theoretically, companies have an insatiable appetite for growth; by this we mean that companies wish to promote increases in sales and, presumably profits, ad infinitum. They are never fully satisfied and always want more.

In discussing the External Funds Needed model, we observed that, in order to grow, companies must increase their short- and long-term assets. More assets are required in order to produce more goods and services. This should lead to increased profits.

We shall identify three means by which long-term assets^[1] may be acquired: with cash, with debt financing, and via leasing. Each of these choices affect Capital Structure. Naturally, the acquisition may also be done in some combination of these three, but we will not discuss that possibility here. For the moment, our interest resides solely in the effect that the undivided choice of the asset acquisition financing method has on the company’s balance sheet.

In this sub-chapter, we will discuss the intricacies of Leasing, and then return to the more general topic of Financial Leverage using a combination of debt and equity. We will first note that leasing involves a capital structure element and decision.

Cash Acquisition

Should the company choose to purchase the asset with cash, the cash account will be reduced (credited) to pay for the asset, and the (long-term) assets account will be increased (debited) by an amount equal to the new asset’s cost. The firm’s total assets will be unchanged as will its debt ratios. If it decides to pay cash, it must figure into the decision the opportunity cost of cash. This assumes, of course, that the company has sufficient cash to pay for the asset’s acquisition.

To illustrate, let’s say that XYZ Corp. decides to purchase a “fixed asset” for $5,000 and, rather than using equity (cash), it borrows via “long-term debt.” What would the company’s balance sheet (and debt ratio) look like before and after the asset purchase and debt acquisition? (For the debt ratio, use Total Debt (i.e., current plus long-term ÷ total assets.)

Notice that due to the asset purchase and debt financing, fixed assets, debt, total assets, and the debt ratio all go up. Take note also that the asset has been acquired with 100% debt and that no incremental equity was issued.

Leasing

Last, the company may choose to “acquire” the asset by leasing it. (It could also finance the asset with new equity, but we will not cover that alternative.) Leasing is not, in a legal sense, the same as a purchase, however it may be economically equivalent. An accountant, under current GAAP rules, must distinguish between an “operating” and a “financing” or “capital” lease. The accountant will not reflect any balance sheet entries if the lease is an operating one.

If a lease qualifies as a financing lease, the accountant will “capitalize” the leased asset. This involves reflecting some value for the asset on the balance sheet and recording a lease liability as well. For both the operating and financing leases, there will be both income statement (i.e., lease expense) and cash flow statement (i.e., lease payment) entries. Again, our focus here is only on the Balance Sheet and its leverage or capital structure effects.

Thus, leases may be used in lieu of debt, as a financing tool. A lease is not strictly debt in the sense that with debt the company borrows from either a bank or bond investors, and receives cash up front, which is then used for the asset acquisition.

However, in the case of a lease, the company (the “lessee”) commits to a future series of payments for a stated time frame. Payments are made to the “lessor” who provides the company with the use of an asset. There is also often an asset service agreement. Thus, the lessee incurs a legal obligation, requiring that payments be made in the future, much like debt would require.

In the past, leases were considered an “off balance sheet” financing tool as there was no accounting recognition of either the legal or its correlative financial events. Since the asset and its related debt were not recognized on the Balance Sheet, no negative impact was reflected in the company’s debt ratios. As a result, the firm’s financial status appeared stronger than it may actually have been. That policy changed in 1976.