Question 17.7: In its 10-K for the year ended 31 January 2007, Wal-Mart’s (...
In its 10-K for the year ended 31 January 2007, Wal-Mart’s (NYSE: WMT) balance sheet included total obligations under capital leases of $3,798 million, of which $285 million was due within one year and the remainder was long term. The notes to the financial statements also broke out the following information regarding long-term contractual obligations:
Contractual Obligations and Other Commercial Commitments
The following table sets forth certain information concerning our obligations and commitments to make contractual future payments, such as debt and lease agreements, and contingent commitments:
Based on the information given, address the following problems:
1. Contrast the relative importance of on- and off-balance-sheet treatment of contractual obligations for Wal-Mart.
2. Determine the relative importance of Wal-Mart’s off-balance-sheet obligations, given that Wal-Mart’s 2007 cost of sales was $264 billion.
3. Estimate the impact on Wal-Mart’s financial statements if operating leases were treated as though they were capital leases.
| Payments due during fiscal years ending 31 January | |||||
| ($ millions) | Total | 2008 | 2009–2010 | 2011–2012 | Thereafter |
| Recorded Contractual | |||||
| Obligations: | |||||
| Long-term debt | $32,650 | $5,428 | $9,120 | $5,398 | $12,704 |
| Commercial paper | 2,570 | 2,570 | __ | __ | __ |
| Capital lease obligations | 5,715 | 538 | 1,060 | 985 | 3,132 |
| Unrecorded Contractual | |||||
| Obligations: | |||||
| Noncancelable operating leases | 10,446 | 842 | 1,594 | 1,332 | 6,678 |
| Interest on long-term debt | 17,626 | 1,479 | 2,482 | 1,705 | 11,960 |
| Undrawn lines of credit | 6,890 | 3,390 | __ | 3,500 | __ |
| Trade letters of credit | 2,986 | 2,986 | __ | __ | __ |
| Standby letters of credit | 2,247 | 2,247 | __ | __ | __ |
| Purchase obligations | 15,168 | 11,252 | 3,567 | 126 | 223 |
| Total commercial commitments | $96,298 | $30,732 | $17,823 | $13,046 | $34,697 |
Solution to 1. Wal-Mart lists $40.9 billion of recorded contractual obligations ($32.650 + $2.570 + 5.715), and $55.4 ($10.446 + $17.626 + $6.890 + $2.986 + $2.247 + $15.168) billion of future obligations that are not recorded on the balance sheet.
Solution to 2. Noncancelable operating leases are similar in nature to capital leases, or assets financed with debt. They should be treated as though they were capital leases. The interest on long-term debt is the total future sum, and represents a financing cost rather than an actual liability. Analysis of interest coverage ratios should be adequate, with no adjustments to financial statements required. Undrawn lines of credit represent credit available, not currently in use. It is a potential obligation rather than an actual one. Letters of credit and purchase obligations are normal parts of business, and the related amounts ($20.4 billion) are small relative to Wal-Mart’s operations.
Wal-Mart’s 2007 cost of sales was $264 billion—so the $15 billion in purchase obligations (which will eventually flow through cost of sales) amounts to less than three weeks worth of the actual purchases by Wal-Mart.
Solution to 3. The present value of Wal-Mart’s operating leases can be estimated by comparing them to its capital leases. Ideally, an analyst would discount the future capital lease payments, $5,715, to their carrying value of $3,798 to determine the implicit interest rate (an internal rate of return), then discount the operating lease obligations at the same rate. However, the disclosures give only broad ranges of when the payments are due, so analysts must estimate the timing. A shortcut approach is to simply apply the same overall discount to each type of lease. So, if the present value of capital leases is $3,798 ÷ $5,715 = 66.5% of the future payments, the present value of operating leases would be estimated at $10,446 × 0.665 = $6,942. To capitalize the operating leases, the analyst would add $6,942 to property, plant, and equipment and also to long-term liabilities. Leverage ratios, asset turnover, and other ratios involving assets and liabilities would be affected. In addition, the existing lease payments would ideally be allocated to depreciation and interest components rather than the current classification as rent. This would also impact interest coverage ratios and operating margins. The precise impact would depend on the amortization assumptions made.
Note: Operating lease obligations of $10.4 billion are 1.83 times larger than the $5.7 billion in capital leases. The operating leases are slightly longer duration, as evidenced by the fact that 64 percent ($6,678 ÷ $10,446) of the payments are due in more than five years, compared with 55 percent ($3,132 ÷ $5,715) of the capital lease payments.
Because the payments are due over a longer time horizon, their discounted value is lower, and the $6.9 billion estimated value is somewhat high (though considerably more accurate than the current balance sheet valuation of zero).