How Healthy Is the Balance Sheet with All Those Leases?

Common Investing Pitfall: How Healthy Is the Balance Sheet with All Those Leases?

Many retailers use operating leases to "rent" space for their stores. Because these leases aren't capitalized and are kept off the balance sheet, they understate a firm's total financial obligations and can artificially inflate financial health. The leases aren't inherently bad or sneaky; in fact, their existence is core to most retailer's expansion plans. Lease obligations can be found in the footnotes of a firm's 10-K under the heading "commitment and contingencies."

Be sure to give a retailer a thorough checkup before declaring it to be in tip-top financial shape.

For example, Tommy Hilfiger appeared to have pretty good financial health going into 2002. The firm had $387 million in cash and $638 million in total debt. However, the specialty apparel firm also had $273 million of future financial obligations in the form of operting leases. If we add off-balance sheet leases to the debt on the balance sheet, the toal comes to $911 million, and the coverage ratios don't look as robust. Tommy Hilfiger entered 2002 with declining sales and stagnating profits and cash flow. When Hilfiger announced that it neede to close many of its retail stores in October 2002 and pay to break the leases, the stock price was hammered.