Capital Lease vs Operating Lease

Under U.S. GAAP (ASC 842), a lease is a finance (capital) lease if it meets ANY of five criteria: (1) ownership transfers to the lessee at the end, (2) there's a bargain purchase option the lessee is reasonably certain to exercise, (3) the lease term is for the major part of the asset's remaining useful life, (4) the present value of lease payments equals substantially all of the asset's fair value, or (5) the asset is so specialized it has no alternative use to the lessor. If none are met, it's an operating lease. The old 'bright-line' rules (75% of useful life, 90% of fair value) are now guidelines rather than hard cutoffs, but interviewers still reference them.

This is the key difference that survives ASC 842. A finance lease splits the payment into two pieces: depreciation of the right-of-use asset (usually straight-line) and interest on the lease liability (front-loaded, like any amortizing loan). Because interest and depreciation are BOTH excluded from EBITDA, a finance lease produces higher EBITDA and higher EBIT in later years. An operating lease records a single straight-line lease expense that sits entirely within operating expenses — so it reduces EBITDA and EBIT. Total expense over the life is identical; only the timing and geography differ.

On the balance sheet, both lease types now record a right-of-use (ROU) asset and a corresponding lease liability at the present value of payments. The difference appears in subsequent measurement and on the cash flow statement. For a finance lease, the principal portion of payments is a financing outflow and interest is operating (or financing) — boosting operating cash flow. For an operating lease, the entire payment is an operating outflow. This means finance leases flatter both EBITDA and operating cash flow, which matters when a company is valued on those metrics.

Because finance leases lift EBITDA while operating leases depress it, two companies that lease identical fleets can show very different EV/EBITDA multiples purely from lease classification. Analysts often capitalize operating leases (treating them as debt-like) to make comparisons fair — adding the lease liability to enterprise value and adjusting EBITDA. Credit analysts always treat lease obligations as debt-equivalents in leverage ratios like Debt/EBITDA, because a lease is a fixed, contractual obligation just like a loan.