For anyone who was invested in Enron, off-balance sheet (OBS) financing is a scary term. 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 and liability.
Common forms of off-balance sheet financing include operating leases and partnerships. Operating leases have been widely used over the years, although the accounting rules have been tightened to lessen the use. For example, a company can rent or lease a piece of equipment and then buy the equipment at the end of the lease period for a minimal amount of money, or it can buy the equipment outright. In both cases, a company will eventually own the equipment or building. The difference is in how a company accounts for the purchase. 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 using the operating lease, the company is recording only rental expense, which is significantly lower than booking the entire purchase price, resulting in a cleaner balance sheet.
Partnerships are another common OBS financing item, and this is the way Enron hid its liabilities. When a company engages in a partnership, even if the company has a controlling interest, it does not have to show the partnership’s liabilities on its balance sheet, again resulting in a cleaner balance sheet.
These two examples of OBS financing arrangements depict the reason their use is attractive to many companies. The problem investors encounter when analyzing a company’s financial statements is that many of these OBS financing agreements are not required to be disclosed at all, or they have partial disclosures, which are very minimal and do not provide adequate data required to fully understand a company’s total debt. Even more perplexing is that these financing arrangements are allowable under current accounting rules, although some rules govern how each can be used. Because of the lack of full disclosure, investors need to determine the worthiness of the reported statements prior to investing by understanding any OBS arrangements.
Why OBS Financing is So Attractive
OBS financing is very attractive to all companies, but especially to those that are already highly levered. For a company that has high debt to equity, increasing its debt may be problematic for several reasons.
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 (called covenants) between the borrower and lender to be violated.
Third, partnerships, 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. This is particularly true in the pharmaceutical industry where R&D for new drugs takes many years to complete.
Last, OBS financing can often create liquidity for a company. For example, if a company uses an operating lease, capital is not tied up in buying the equipment since only rental expense is paid out.
How OBS Financing Affects Investors
Financial ratios are used to analyze a company’s financial standing. OBS financing affects the leverage ratios, like the debt ratio, a common ratio used to determine if the debt level is too high when compared to a company's assets. Debt-to-equity, another leverage ratio, is perhaps the most common because it looks at a company's ability to finance its operations long term using shareholder equity instead of debt. The debt-to-equity ratio does not include short-term debt used in a company's day-to-day operations to more accurately depict a company’s financial strength.
In addition to the debt ratios, other OBS financing situations include operating leases and sale-lease back impact liquidity ratios. Sale-lease back is a situation where a company sells a large asset, usually a fixed asset like a building or large capital equipment, and then leases it back from the purchaser. Sale-lease back arrangements increase liquidity because they show a large cash inflow after the sale and a small nominal cash outflow for booking a rental expense instead of a capital purchase. This reduces the cash outflow level tremendously, so the liquidity ratios are also affected. Current assets to current liabilities is a common liquidity ratio used to assess a company’s ability to meet its short-term obligations. The higher the ratio, the better the ability to cover current liabilities. The cash inflow from the sale increases the current assets, making the liquidity ratio more favorable.
The Bottom Line
OBS financing arrangements are discretionary, and although they are allowable under accounting standards, some rules govern how they can be used. Despite these rules, which are minimal, the use complicates investors’ ability to critically analyze a company’s financial position. Investors need to read the full financial statements, such as 10Ks, and look for key words that may signal the use of OBS financing. Some of those key words include partnerships, rental or lease expenses, and investors should be critical of their appropriateness. Analyzing these documents is important, because accounting standards require some disclosures such as operating leases in the footnotes. Investors should always contact company management to clarify if OBS financing agreements are being used and the extent to which they affect a company's true liabilities. A keen understanding of a company’s financial position today and in the future is key to making an informed and sound investment decision.
What is an 'Off Balance Sheet - OBS'
Off balance sheet (OBS) items refer to assets or liabilities that do not appear on a company's balance sheet but that are nonetheless effectively assets or liabilities of the company. Assets or liabilities designated off balance sheet are typically ones that a company is not the recognized legal owner of, or in the case of a liability, does not have direct legal responsibility for. As an example, although loans issued by a bank are ordinarily kept on the bank's balance sheet, when some loans are securitized and sold off as investments, that securitized debt will be kept off the bank's books, and an operating lease is one of the most common off-balance items.
BREAKING DOWN 'Off Balance Sheet - OBS'Off balance sheet items are an important concern for investors in regard to assessing a company's financial health. Off balance sheet items are often difficult to identify and track within a company's financial statements because they usually only appear in the accompanying notes. Another concern is that some off balance sheet items have the potential to become hidden liabilities. For example, collateralized debt obligations (CDO), where assets that make up the CDO are debt obligations, can become toxic assets — ones that can suddenly become almost completely illiquid — before investors are aware of the company's financial exposure, because the CDOs are off balance sheet items.
Off balance sheet items are not inherently intended to be deceptive or misleading to investors. Certain types of businesses routinely keep substantial off balance sheet items. For example, investment management firms are required to keep clients' investments and assets off balance sheet. For most companies, off balance sheet items exist in relation to financing, enabling the company to maintain compliance with existing financial covenants. Off balance sheet items are also used to share both risks and benefits of assets and liabilities with other companies, as in the case of joint venture projects.
How Off Balance Sheet Financing Works
An operating lease, used in off balance sheet financing, is a good example of a common off balance sheet item. Assume that a company has an established line of credit with a bank and that a financial covenant condition for the bank extending credit is that the company must maintain its debt-to-assets ratio below a specified level. Taking on additional debt to finance the purchase of new computer hardware would violate the line of credit covenant by raising the debt-to-assets ratio above the maximum specified level.
The company solves its financing problem by using a subsidiary or special purpose entity (SPE), which purchases the hardware and then leases it to the company through an operating lease, a contract allowing use of the equipment, while legal ownership is retained by the separate entity. The company only has to record the lease expense on its financial statements. Even though it effectively controls the purchased equipment, the company does not have to recognize additional debt nor list the equipment as an asset on its balance sheet.