What is the impact of leases on debt covenants and interest coverage ratios in a model?

• A. Leases do not affect debt covenants.
• B. Leases increase assets but not liabilities.
• C. Leases increase liabilities and interest expense, weakening covenants.
• D. Leases decrease liabilities.

Answer: (C)

Leases impact debt covenants and interest coverage by bringing lease obligations onto the balance sheet and affecting the income statement. When a lease is recognized, a lease liability is recorded, creating additional debt, and a right-of-use asset is added. In the income statement, you now show depreciation on the right-of-use asset and interest on the lease liability, replacing the former lease expense. This increases the reported debt level and raises interest expense while lowering EBIT due to depreciation. Because covenants often use debt levels and interest expense (or related coverage ratios like EBIT/Interest or EBITDA/Interest), the higher debt and higher interest expense tend to tighten or weaken these covenants. In short, leases add liabilities and boost interest expense, which generally diminishes debt covenants and reduces interest coverage.