How does asset finance affect my company’s balance sheet?

Asset finance, such as leasing or hire purchase agreements, is a crucial funding tool for businesses seeking new equipment, vehicles, or machinery without significant upfront capital expenditure. However, the decision to use asset finance profoundly impacts a company’s financial reporting and key performance indicators. The specific way asset finance affects your company’s balance sheet depends heavily on the structure of the agreement and, crucially, the accounting standards your business uses, particularly the transition from older standards (like IAS 17) to the modern IFRS 16.

How Does Asset Finance Affect My Company’s Balance Sheet?

The core function of asset finance is to allow businesses access to essential equipment—from servers and construction machinery to commercial vehicles—by spreading the cost over time. From an accounting perspective, the impact is determined by whether the arrangement is classified as a loan (where ownership is transferred immediately or eventually) or a lease (a right to use the asset).

Historically, the goal for many businesses was “off-balance-sheet financing.” This meant structuring deals, typically as operating leases, so that the asset and the associated debt did not appear on the balance sheet, thereby keeping gearing ratios low. However, modern accounting rules have largely eliminated this approach for most finance arrangements.

The Shift in Accounting Standards: IFRS 16

For UK companies reporting under International Financial Reporting Standards (IFRS)—which includes all publicly listed companies and many larger private entities—the transition from International Accounting Standard 17 (IAS 17) to IFRS 16 Leases, effective from 1 January 2019, fundamentally changed how asset finance is recorded. IFRS 16 introduced a single, comprehensive model for lease accounting.

Pre-IFRS 16 Treatment (IAS 17)

Before IFRS 16, the classification between operating leases and finance leases was central:

• Finance Lease (Capital Lease): This transferred substantially all the risks and rewards of ownership to the lessee. The asset and the liability were recognised on the balance sheet.
• Operating Lease: This did not transfer substantially all the risks and rewards of ownership. Payments were treated as an expense on the income statement only, keeping the debt off the balance sheet.

The Current Standard: IFRS 16 Leases

IFRS 16 largely abolished the distinction between operating and finance leases for the lessee (the company using the asset). Under IFRS 16, virtually all leases with a term longer than 12 months are treated as finance leases, leading to significant changes in the balance sheet structure.

When your company enters into an asset finance agreement that meets the definition of a lease under IFRS 16, the following entries are typically made:

1. Recognition of the Right-of-Use (ROU) Asset

The company must recognise an asset on the balance sheet representing its right to use the underlying equipment for the duration of the lease term. This ROU asset is typically recorded under Non-Current Assets (Fixed Assets) and is initially measured at the present value of the lease payments plus any initial direct costs.

2. Recognition of the Lease Liability

Simultaneously, a corresponding liability is recognised on the balance sheet, representing the obligation to make future lease payments. This liability is split between Current Liabilities (payments due within 12 months) and Non-Current Liabilities (payments due after 12 months).

The immediate effect is that both the company’s gross assets and gross liabilities increase substantially. This transparency means that analysts and creditors gain a much clearer picture of the true scale of a company’s financial commitments.

Impact of Specific Asset Finance Methods

While IFRS 16 governs leases, other forms of asset finance, where the intention is eventual ownership, have always been treated as on-balance sheet debt.

Hire Purchase (HP) and Conditional Sale

In a Hire Purchase agreement, the company immediately obtains the use of the asset and commits to acquiring ownership upon the final payment. Because the company takes on the risks and rewards of ownership from the start, HP is treated as a secured loan:

• The full value of the asset is recorded on the balance sheet under Non-Current Assets.
• A corresponding liability (the outstanding debt) is recorded under liabilities.
• The asset is depreciated over its useful life, affecting the income statement.
• Repayments are treated as a mix of principal reduction (affecting the liability) and interest expense (affecting the income statement).

Finance Leases (Under IFRS 16)

As detailed above, most modern long-term leases are treated as finance leases. While the ROU asset is recognised and depreciated, the liability component requires careful management. Interest expenses are recognised separately from the depreciation charge, meaning expense recognition is generally higher at the beginning of the lease term and lower towards the end.

Operating Leases (Short-Term Exception)

IFRS 16 does allow limited exceptions for certain short-term leases (12 months or less) and leases of low-value assets (such as small office equipment). These leases may still be treated as off-balance-sheet items, with payments expensed directly to the income statement as they are incurred. However, companies must elect this exemption and ensure it applies rigorously.

For more detailed compliance information regarding IFRS 16 application in the UK, businesses often consult guidance issued by the Financial Reporting Council (FRC) or similar advisory bodies. Understanding these rules is key to accurate financial reporting, which is mandatory for many companies under UK law. You can review government guidance on reporting standards here.

How Asset Finance Impacts Key Financial Ratios

The recognition of ROU assets and lease liabilities under IFRS 16 significantly alters how key financial metrics are calculated, often giving the impression of higher indebtedness compared to pre-2019 reporting.

1. Gearing and Solvency Ratios

Gearing ratios (Debt-to-Equity or Net Debt-to-EBITDA) are used by lenders and investors to assess a company’s ability to meet its long-term obligations. Since lease liabilities are now counted as debt, gearing ratios typically increase.

• Higher gearing can make obtaining future traditional bank loans more challenging, as the company appears more leveraged.
• Companies that have restrictive loan covenants based on maintaining specific gearing thresholds may find themselves closer to breaching these covenants due to the change in accounting treatment.

2. Profitability and EBITDA

The change also affects the income statement and profitability metrics:

• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation): Under the old operating lease system, lease payments were treated as an operational expense, reducing EBITDA. Under IFRS 16, ROU asset depreciation and lease interest expense replace the operational lease payment. Because depreciation and interest are added back to calculate EBITDA, the reported EBITDA figure generally increases under IFRS 16.
• Net Profit: While EBITDA may increase, Net Profit is often lower in the initial years of the lease. This is because depreciation on the ROU asset is typically straight-line, while the interest expense reduces over time (front-loaded interest), resulting in higher total expenses earlier in the lease term.

3. Return on Assets (ROA)

ROA measures how efficiently a company uses its assets to generate profit. Since the ROU asset is added to the balance sheet denominator, and net profit may temporarily decrease (due to front-loaded expenses), the Return on Assets ratio typically decreases after the adoption of IFRS 16 for companies that rely heavily on leased assets.

People also asked

What is the benefit of recognising lease liabilities on the balance sheet?

The primary benefit is enhanced financial transparency. By recording assets and associated obligations, investors, lenders, and stakeholders gain a complete and accurate view of the company’s total economic resources and commitments, making financial comparisons between companies more reliable.

Does IFRS 16 apply to all UK businesses?

IFRS 16 applies to all UK companies that report using IFRS, which is mandatory for listed companies and commonly adopted by large private companies. Smaller companies and those reporting under FRS 102 (UK Generally Accepted Accounting Practice, or UK GAAP) still largely follow the older IAS 17 approach, distinguishing between operating and finance leases.

What is a Right-of-Use (ROU) asset?

A Right-of-Use (ROU) asset is a financial term used under IFRS 16 to represent a lessee’s right to control the use of an identified asset (like a piece of machinery or property) for a specified period. It is recognised on the balance sheet as a non-current asset.

Do short-term leases always stay off the balance sheet?

No, not always. IFRS 16 provides an optional exemption for short-term leases (those with a lease term of 12 months or less) and leases of low-value assets. Companies must formally elect to use this practical expedient; otherwise, standard recognition rules apply.

How does asset finance affect cash flow statements?

Under IFRS 16, cash flow statements change significantly. Previously, operational lease payments were classified as operating activities. Now, the cash outflow is split: the repayment of the lease liability is classified as a financing activity, while the interest component may be classified as either operating or financing activity, depending on the company’s policy.

Conclusion

Asset finance remains a flexible and advantageous way to acquire essential business resources. However, when evaluating funding options, UK businesses must fully understand the accounting implications, particularly the mandatory requirements of IFRS 16. The primary impact is shifting debt onto the balance sheet, which requires careful management of financial covenants and reporting to stakeholders. Professional financial advice should always be sought to ensure that any chosen asset finance route aligns not only with operational needs but also with regulatory compliance and strategic financial goals.