What is Off-Balance Sheet Financing?
A form of financing in which large capital expenditures are kept off a company’s balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep their debt-equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants. A company may image in Off-balance sheet financing if it wishes to keep its debt-equity ratio low and thereby appear as if it is carrying little debt.
Financing that does riot appear on a company’s balance sheet because it is not strictly debt, so liabilities and associated assets are excluded from the balance sheet.
Off-balance sheet financing means a company does not include a liability on its balance sheet. It is an accounting term and impacts a company’s level of debt & liability.
Why Use Off-Balance Sheet Financing?
Off-Balance Sheet is very attractive to all companies, but especially to those that are already highly levered.
First, for Companies that already have high debt levels, borrowing more money is usually exceedingly more expensive than for companies that have little debt because the interest charged by the lender is high.
Second, Borrowing more may increase a company’s leverage ratios, causing agreements between the borrower and lender to be violated.
Third, such as in research and development, are attractive to companies because R&D is expensive and may have a long-time horizon before completion. The accounting benefits of partnerships are many-fold.
For example, accounting for an R&D partnership allows the company to add very minimal liability to its balance sheet while conducting the research. This is beneficial because, during the research process, there is no high-value asset to help offset the large liability.
Forth, Off-Balance Sheet financing can often create liquidity for a company. For example, if a company uses an operating Jease, capital is not tied up in buying the equipment since the only rental expense is paid out.
Examples of Off-Balance Sheet Financing
Operating Leases
In an operating lease, the company records only the rental expense for the equipment rather than the full cost of buying it outright. When a company buys it outright, it records the asset (the equipment) and the liability (the purchase price).
So by the use of an operating lease, the company is recording only rental expenses, which is significantly lower than booking the entire purchase price, resulting in a cleaner balance sheet.
Partnership Firm
A partnership is another common off-balance-sheet financing item, and this is the way Enron hid its liabilities.
When a company engages in a partnership, even if it has a controlling interest, it does not have to show the partnership’s liabilities on its balance sheet, resulting in a cleaner balance sheet.
Evaluated by the Analyst
The analyst must be aware that some management will attempt to understate debt and that new methods are constantly tried.
A careful reading of footnotes and management comments, along with inquires of management, can shed light on the existence of unrecorded liabilities.
Required Disclosures for Financial Instruments with Off-Balance Sheet Financing Risk of Accounting Loss to SFAS-105
This accounting standard establishes requirements for all entities to disclose information about financial instruments with the off-balance-sheet risk of accounting loss.
All entities will be required to disclose the following information about financial instruments with the off-balance-sheet risk of accounting.
- The face, contract, or notional principal amount.
- The nature and terms of the instruments and discussion of their credit and market risk, cash requirements, and related accounting policies.
- The accounting loss the entity would incur if any party to be financial instruments failed to perform according to the terms of the contract, and collateral or other security, if any, for the amount due proved to be of no value to the entity.
- The entity’s policy for requiring collateral or other, security on financial instruments it accepts, and a description of collateral on instruments presently held.
