What does off-balance sheet financing mean

Off-balance sheet financing

What is off-balance sheet finance?

Off-balance sheet financing is the company's practice of excluding certain liabilities and, in some cases, assets from accounting to keep ratios such as debt-to-equity ratios low, to facilitate financing at a lower interest rate, and also to avoid the violation of Agreements between the lender and the borrower.

It is a liability that is not recorded directly on the company's balance sheet. Off-balance sheet items are of sufficient significance because, even if not included in balance sheet finance, they represent the liability of the company and should be included in the overall analysis of the company's financial position.

How does it work?

For example, let's say ABC Manufacturers Ltd is undergoing an expansion plan and wants to buy machinery to build its second unit in another state. However, there is no funding agreement as the balance sheet is already heavily funded. In such a case there are two options. It can create a joint venture with other investors or companies to create a new entity and obtain new funding on behalf of the new company. On the other hand, it can also enter into the long-term rental agreement with the equipment manufacturer for the leasing of machines, in which case it does not have to worry about new financing. Both of the above cases are examples of off-balance sheet financing.

What is the purpose of off-balance sheet items?

  1. To keep the solvency ratio such as the debt ratio below a certain level and obtain funding that the company would otherwise not have been able to obtain.
  2. Better solvency ratios ensure a good credit rating, which enables the company to get access to cheaper finance.
  3. This makes balance sheet financing appear leaner, which at first glance can attract investors.

Key Features

  1. This leads to a reduction in the existing assets or the exclusion of assets from the balance sheet.
  2. The company's capital structure is changing.
  3. Both assets and liabilities are undervalued and give a leaner impression of balance sheet funding.
  4. It involves using creative accounting and financial tools to achieve off-balance sheet funding.

List of off-balance sheet finance items

The following are some of the common tools used for off-balance sheet items.

# 1 - leasing

It is the oldest form of off-balance sheet financing. By leasing an asset, the company can avoid recognizing the financing of the asset from its liabilities, and leasing or renting is recognized directly as an expense in the income statement.

  1. For the lessee, this is the source of finance as the lessor bears the financing of the asset.
  2. The traditional method of acquiring assets that require a significant capital outlay;
  3. This makes it easier to upgrade the technology as times change.
  4. Only operating leases are considered off-balance sheet finance and finance leases must be capitalized on the balance sheet in accordance with the latest Indian accounting standards.

# 2 - special vehicle (SPV)

Special purpose vehicles or subsidiaries are one of the routine methods of creating balance sheet financing risks. It was used by Enron, which is known for one of the most well-known controversies surrounding off-balance sheet financing risk.

  1. The parent company creates SPV to conduct new activities but wants to isolate itself from the risks and liabilities from new activities.
  2. The parent company is not required to include SPV's assets and liabilities on its balance sheet.
  3. The special purpose vehicle acts as an independent unit and acquires its credit lines for new business.
  4. If the parent company wholly owns SPV, accounting standards for most countries require it to consolidate the SPV balance sheet into its own, defeating the purpose of creating off-balance sheet funding. Therefore, companies usually set up SPV through the new joint venture with another company.

# 3 - Lease Purchase Agreements

If a company cannot afford to buy or obtain funding for assets directly, it can enter into a lease purchase agreement with financiers for a period of time. A financier buys the asset for the company, which in turn pays a fixed amount each month until all contract terms are met. The tenant has the option to own the asset at the end of the lease purchase agreement.

  1. Under normal accounting, the asset is shown on the buyer's balance sheet and the renter is not required to show it on their balance sheet during the period of the lease-purchase agreement.

# 4 - factorization

It is a type of credit service that banks and other financial institutions offer their existing customers. Under factoring, financing is achieved through the sale of receivables to banks. Banks immediately offer cash to the company after cutting the demands for offering the service.

  1. It is sometimes referred to as accelerating cash flow.
  2. The company has no direct liability due to factoring, but some of its assets are sold.

Importance for investors

According to the accounting standards for almost all major countries, it is mandatory to fully disclose all off-balance sheet financial items for the company for the respective year. Investors should read this information in order to fully understand the risks associated with such transactions.