H&M’s ROIC incl. Value of Leased Assets

Operating leases – an off-balance sheet item

Operating leases play an important part for most retailers since they lease their stores in which business is being done. The option would be to own all the necessary real estate.

Due to the current accounting rules (in the case of H&M International Financial Reporting Standards – IFRS) the value of leased assets are treated as an off-balance sheet item. Rental costs are recognized in the income statement as an expense linearly over the term of the leasing agreement.

To get a better understanding of the returns generated by a business, an investor needs to make some adjustments to see the underlying return on invested capital including the value of leased assets.

From this I thought I would write a few words about Hennes & Mauritz (STO:HM-B), the Swedish retailer, and their operating leases, and how to think about lease accounting as of today and what to do about this when calculating the well-known financial metric returns on invested capital, often referred to as ROIC.

H&M’s return as reported in annual reports

In the annual reports H&M has reported the following numbers regarding their Return on Equity and Return on Capital Employed:


The ratios in the table above are calculated by H&M as follows:

  • Return on shareholders’ equity: Profit for the year divided by shareholders’ equity.
  • Return on capital employed: Profit after financial items plus interest expense divided by shareholders’ equity plus interest-bearing liabilities.

From the table above, the returns achieved by H&M in the last decade have been pretty good. But as a retailer H&M accounts for operating leases as an off-balance sheet item. If operating leases where accounted for as an asset (and a liability) ROIC would be affected due to the effects on operating profit and invested capital. Return on equity would not change, it would still show the same return, including operating leases as an asset or not.

In the accounting principles section in the notes to the financial statements H&M describes how leasing is accounted as follows.

“Leasing agreements in which a substantial portion of the risks and benefits of ownership are retained by the lessor are classified as operational leases. Financial leases exist when the financial risks and benefits associated with the ownership of an object are essentially transferred from the lessor to the lessee, regardless of whether the legal ownership lies with the lessor or the lessee. Assets held under financial leases are reported as fixed assets and future payment commitments are reported as liabilities in the balance sheet. As of the closing date the Group had no financial leases. Minimal leasing agreements relating to operational leases are recognised in the income statement as an expense and distributed linearly over the term of the agreement. The Group’s main leases are rental agreements for premises. Variable (sales-based) rents are recognised in the same period as the corresponding sales.” H&M Annual Report 2013 

In note 12 Buildings, Land and Equipment H&M reports their rental costs for the 2013 financial year that amounted to SEK 15,044 million, compared to SEK 14,056 million in 2012. 

Note 8 Depreciation states that depreciation has been calculated at 12 percent of the acquisition cost of leasehold rights. H&M has some leasehold rights accounted for as financial leases, which are on-balance sheet. These are depreciated over 8.3 years (1/0.12). Below I will use this length of useful life as a best guess for the asset life of operating leases when calculating the value of leased assets from these.

Thinking about operating leases

So, what is the most proper way to treat leases when trying to figure out the underlying returns of a business and to be able to compare returns on invested capital among different retailers?

In the book Valuation – Measuring and Managing the Value of Companies the authors discuss their view of operating leases and how to treat them in a financial analysis.

“When a company borrows money to purchase an asset, the asset and debt are recorded on the company’s balance sheet, and interest is deducted from operating profit to determine net income. If, instead, the company leases that same asset from another organization (the lessor) and the lease meets certain criteria, the company (or lessee) records only the periodic rental expense associated with the lease. Therefore, a company that chooses to lease its assets will have artificially low operating profits (because rental expenses include an implicit interest expense) and artificially high capital productivity (because the assets do not appear on the lessee’s balance sheet). Although these two effects counteract one another, the net effect is an artificial boost in ROIC, because the reduction in operating profit by rental expense is typically smaller than the reduction in invested capital caused by omitting assets. The result is especially dramatic for profitable companies that lease a substantial portion of their fixed assets, as is typical of retailers and airlines.” – Valuation – Measuring and Managing the Value of Companies, 5th edition

To calculate the value of operating leases the following formula from the book Valuation (see reference above) was used:

Asset Value = Rental Expense / (Cost of Debt + (1 / Asset Life))

  • The numbers for rental expense was taken directly from disclosure in the notes in H&M’s annual reports.
  • Cost of Debt was assumed to be 4%.
  • Asset life was assumed to be 8.3 years from the disclosure in the notes about depreciation of 12% for capitalized leases.

I have made some assumptions about cost of debt and asset life that hopefully are reasonable. As Keynes once said “It is better to be approximately right than precisely wrong.” 

See table below for different calculations.


Comparing return on invested capital including the value of leased assets shows a materially lower return compared to the calculation of return on capital employed without these leases. See comparison in the table below.


The diagram below shows the adjusted operating margin, return on invested capital incl. value of leased assets, and the invested capital turnover during the last decade.


So, returns on invested capital including operating leases differ materially from the same calculation without including them. To be able to see the underlying returns a business is able to generate and also to be able to compare different companies, it’s very important not to forget to think about how to treat operating leases in a proper way.


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