Doc Martens and Operating Leases


The intention behind IFRS 16, which brings notional lease liabilities on to the balance sheet, was to assist investors and lenders who wanted to understand the true indebtedness of the companies they were lending to and investing in. Unfortunately, it’s a mess. Accounts are if anything LESS comparable than previously.

This hasn’t presented much of a problem to me – I tend not to be invested in stocks where operating leases are a significant component (or where I have been, the entry point was in March, 2020, so the stocks were very depressed). And client work hardly touched on the subject, until recently, but I have been receiving an increasing number of inquiries about IFRS 16 specifically. I therefore set out to write a blog and this is likely to be the first of a series.

When they constructed these standards, the accounting authorities should have had helping investors as one of their primary aims. If so, they have failed miserably, in my view. Most investors were formerly able to make their own adjustments, but now there is scope for significant confusion. More of that in a moment. First, it might help to explain the mechanics.


When a retailer or a hotelier opens a new shop or hotel, they have a number of choices. To simplify, let’s just say they can either buy the property or rent it. If they buy it, the asset goes in the balance sheet and they have lower cash or higher debt and a building in fixed assets – that building will attract expenses over time, including interest cost, depreciation and maintenance. Let’s call this Company O (for Old-fashioned).

If they rent it, there will be no asset in the balance sheet, and profits will be lower, because the landlord has to make a profit so the rent will be greater than the building’s finance costs, depreciation and maintenance. But the balance sheet will not carry the asset, so the business will require less capital. Let’s call this Company F (for Fashionable).

Company O has higher margins, more assets and a lower return on capital and may attract a lower rating than Company F, because its financial return metrics look less attractive. But any investor can see what they are buying – a higher asset backing which depresses returns but which makes the company more resilient in two ways:

1                          it has more resilience in a downturn as it has less fixed costs

2                          it has higher asset backing

Company F has lower margins but higher returns and may therefore often attract a higher rating. Company F may well grow faster as it requires less capital to grow, further boosting the rating. This is straightforward so far, but let’s turn this into a more concrete example. Let’s say our retailer (company F) had a gross margin of just under 60%. Rents were just 4% of sales, with SG&A in total c.40%, leaving an ebit margin of 20%. Return on capital employed was 26%.

Now let’s say that we had an identical retailer, Company O, but instead of renting its stores, it owns all of them outright. Now obviously, the exact shape of its balance sheet would depend on how long it had owned the stores – if it had owned them for a long time, the asset would be depreciated in the balance sheet and the debt taken on at purchase would have been partly paid down over time by the margin between the rent and the total building ownership costs.

The ownership duration makes the exercise more complicated, but the maximum difference will be on day 1 – the day that the shops are acquired, when there is the maximum debt and maximum asset value. Let’s ignore the margin between owning and renting in year 1 and look at the position at the time of the acquisition.

Our rent was 4% of sales and let’s assume that there is a 5% yield on the property, so we are adding 80% of sales to the capital employed – effectively doubling it. In this example, our returns fall from 26% to 16%. This is shown in the table below:

Source: Behind the Balance Sheet

Source: Behind the Balance Sheet

Source: Doctor Martens website

Source: Doctor Martens website

You will see that we have made some slight adjustments to the numbers above, because this is not a made-up example, but it represents the results for the 6 months to September, 2020 for Dr Martens, the recent London float.

The 72% value for the shop on the balance sheet as % sales is simply the rent of 3.6% x 20 (inverse of the 5% yield). For Co F, we show the rent and for Co O we should show the maintenance cost of the building (and interest on the related borrowings below the operating line).

In its Prospectus, the company explains the impact of IFRS 16 and I shall use this as an example to explain how it works. I confess that I have had some difficulty understanding it myself, as the numbers being presented in practice are rather different from the illustrative example above.


 Let’s look at each of the three financial statements and the adjustments introduced as a result of the adoption of IFRS 16.


The adjustment at the operating profit level is very small as depreciation on the notional assets which have been added to the balance sheet (see below) is very close to the operating lease rental. This is coincidental, and different companies will likely be affected to varying degrees. So operating profit after adoption of IFRS 16 is £64.8m vs £65.0m before.

Source: Doctor Martens Prospectus

Source: Doctor Martens Prospectus

But there is a major difference at the EBITDA level – EBITDA is INCREASED by the value of the lease rental. The theory, as I understand it, is that there is no longer such an item as operating lease rentals in the IFRS accounts and EBITDA has been redefined. EBITDA has always been an over-rated financial parameter, in my view, as it gives no clue as to quality of accounting (especially “Adjusted EBITDA”), it tells you nothing about liquidity and it ignores reinvestment requirements, to name just three criticisms. Now its utility is seriously impaired, and if you are using a debt:EBITDA metric, the debt now includes notional debt added to the balance sheet (whose calculation is subjective), and the EBITDA excludes a real cash expense. This may not matter for a while as covenants will require the calculation to be made in “old money”, but this could become a problem down the road.

The other adjustment to the P&L Is the inclusion of notional lease interest – so the total IFRS 16 expense is £13.6m which creates a £2.1m downward revision to pretax profit and earnings as the tax charge is unaffected. The numbers are not that material for Doc Martens, but there will be cases where they are more significant and we shall return to this topic in a later blog.


This looks a little more complicated but it’s really quite straightforward in principle, although less so in practice. I am going to focus on the adjustments to the opening balance sheet, as the movements are reflected in the P&L.

Source: Doctor Martens Prospectus

Source: Doctor Martens Prospectus

The first adjustment is the Right of Use Asset. Here we can see that £82m has been added to the balance sheet for the shops that Doc Martens was renting at the start of the period. Buried away in the Prospectus is the charge for the prior year which was £18.6m. So the asset of £82m represents just 4.4x the rent or a yield of 22.6%. That would be quite nice to have in a zero interest rate environment and of course it’s totally unrealistic.

Our technical accounting guru, Matt Tilling, would tell you that this is merely a balancing figure and the standard focuses on getting the liability right – that’s an admirable objective, but I am not sure what we should do with this ROU asset – ignore it? That seems a sensible route. The other movements in this asset represent new leases taken out, depreciation of the existing notional asset and translation adjustments as the currencies in which the assets/leases are denominated have moved vs sterling in the period.

There are some minor adjustments to working capital, both receivables and payables, but the principal other adjustment is the calculation of the notional lease liabilities. Here, £21.8m has been added to short term “debt” and £66.6m to longer term “debt”, making £88.4m in total. The short term liability is close to the £21.5m operating lease commitment in the March 2020 balance sheet. Total commitments then amounted to £100.5m with 80% within 5 years.

Source: Doctor Martens Prospectus  

Source: Doctor Martens Prospectus

The liability of £88.4m represents a multiple of 4.75x the prior year’s lease rental. The liability is calculated on a discounted basis using the company’s incremental borrowing rate, which is at the discretion of the CFO, albeit subject to audit. Doc Martens has used 4% – although you may think this looks low, remember that the higher the discount rate, the lower the liability on the balance sheet. This is of course counter intuitive – being aggressive in the estimate of how cheaply you can borrow results in a more conservatively stated balance sheet.

 We should conclude the balance sheet examination by reviewing the debt:EBITDA metric.

Source: Doctor Martens Prospectus

Source: Doctor Martens Prospectus

The redeemable preference shares are a peculiarity of the private equity ownership and were redeemed as part of the IPO process, so the move in the bank debt:EBITDA is the more representative value. I have not yet investigated enough companies to know how representative this is, so it’s something I shall come back to in a future blog on this subject.


Clearly one would not expect any changes in the cash flow, as the adjustments being made here are all notional accounting items – reality hasn’t changed, only the accountants’ view. This is clear from the unchanged Free Cash Flow of £39.7m in the table.

Source: Doctor Martens Prospectus

Source: Doctor Martens Prospectus

What has changed is that cash from operations has been boosted by £10.7m, being the £11.5m reversal of operating lease costs less a reduction in the related payable of £0.8m. As we saw earlier, EBITDA is boosted by the reversal of the lease rental. The corresponding balancing entry is in the Cash from Financing section of the cash flow statement – the line Payment of lease liabilities of £10.7m represents the cash spent on lease rentals in the period. If there are no other leases, this will be equivalent to the cash operating lease rentals, but sometimes for some companies this may be aggregated with finance lease payments, so it will not necessarily be this clear.


I find IFRS16 a difficult accounting standard. I am very much on the learning curve here, as I have never had to handle it in practice and there is a huge difference between trying to understand a change in accounting when at a big hedge fund, looking at hundreds of companies, and being at home as a blogger. So please be patient with me as I explore the subject and try to navigate a path through an accounting minefield. Hopefully this blog will attract some feedback and help from others who have encountered similar issues.

My initial conclusions are that

  • I would prefer to operate in “old money”

  • EBITDA now excludes the cost of operating lease rentals and is really EBITDAR

  • Use of EV:EBITDA or debt:EBITDA metrics on this basis should be done carefully

  • Balance sheet liabilities are subject to discretion by companies

  • Capital employed is similarly subject to discretion

I now need to do some more work to look at how different companies have implemented this in practice. Note also that the rules under US GAAP are quite different from those under IFRS and will be the subject of another blog at some point. Below, our technical accounting guru, Matt Tilling defends IFRS16.



In many ways I agree with Steve’s analysis, IFRS 16 changes things. I know people don’t like change, but in this case, IFRS 16 is a change for the better.

It was estimated that listed companies around the world had almost US$3 trillion of off balance sheet lease commitments in 2015. Investors had long been concerned that there was a lack of transparency about these lease obligations.

At the start of a lease, a lessee is locked into a contract through which it

  • obtains the right to use an asset for a period of time and

  • incurs a liability to make lease payments.

But under previous accounting, a historical quirk meant many leasing transactions were not reported on a lessee’s balance sheet. Instead, an annual rent expense was reported each period. Effectively only a small part of the lease transaction was given visibility. The absence of information about leases on the balance sheet meant that investors and analysts were not able to properly compare companies that borrow to buy assets with those that lease assets, without making estimates and adjustments.

Under IFRS 16 all leases are on the balance sheet. Leases are ‘capitalised’ by recognising the present value of the lease payments and showing them either as lease assets (right-of-use assets) or together with property, plant and equipment. A company also recognises a financial liability representing its obligation to make future lease payments.

The most significant effect of these new requirements is an increase in lease assets and financial liabilities. Companies that had material off balance sheet leases have seen a change to key financial metrics derived from the company’s reported assets and liabilities (for example, leverage ratios). IFRS 16 also changes the nature of expenses related to those leases. IFRS 16 replaces the straight-line operating lease expense with a depreciation charge for the lease asset (included within operating costs) and an interest expense on the lease liability (included within finance costs).

This means that EBITDA will be higher. Previously companies with operating leases recognised rent expense as an operating expense, but now it is reflected in depreciation and interest expense, consistent with companies that had either finance leases or purchased assets outright. So yes, EBITDA changes, but it changes to become consistent, independent of the structure of the financing arrangement.

Consistent doesn’t mean identical – financial statements will reflect the differing operating decisions made by different companies. When a lease is economically similar to borrowing to buy an asset, then the amounts reported applying IFRS 16 will be similar to the amounts that would be reported if the company were to borrow to buy. On the other hand, if the lease is only for part of the life of an asset, this more limited financing arrangement will also be reflected. But the additional disclosure will make this clear.

The problem doesn’t appear to be with IFRS 16 and the capitalisation of leases, the problem seems to be that EBITDA is a dangerous and misleading number to use to assess the value of a company, for all the reasons Steve points out. If you insist, just find the disclosure of total cash outflow for leases (as required by the standard) and subtract it from EBITDA, but understand you are now introducing inconsistencies.