Understanding Off-Balance Sheet Financing

Off-balance sheet (OBS) financing is an accounting practice whereby a company does not include a liability on its balance sheet. It is used to impact a company’s level of debt and liability. The practice has been denigrated by some since it was exposed as a key strategy of the ill-fated energy giant Enron.

Common forms of off-balance sheet financing include operating leases and partnerships. Operating leases have been widely used, although accounting rules have been tightened to lessen the use. 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. If the company chooses an operating lease, the company records only the rental expense for the equipment and does not include the asset on the balance sheet. If the company buys the equipment or building, the company records the asset (the equipment) and the liability (the purchase price). By using the operating lease, the company records only the rental expense, which is significantly less than the entire purchase price and results in a cleaner balance sheet.

Partnerships are another common OBS financing item, and Enron hid its liabilities by creating partnerships. 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 illustrate why companies might use OBS to reduce their liabilities on the balance sheet to seem more appealing to investors. However, the problem that investors encounter when analyzing a company’s financial statements is that many of these OBS financing agreements are not required to be disclosed, or they have partial disclosures. These disclosures do not adequately reflect the 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 must determine the worthiness of the reported statements prior to investing by understanding any OBS arrangements.

OBS financing is attractive to all companies, but particularly 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 typically more expensive than for companies that have little debt because the interest charged by the lender is higher. Second, borrowing may increase a company’s leverage ratios causing agreements (called covenants) between the borrower and lender to be violated.

Third, partnerships, such as in those for R&D, 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. For example, accounting for an R&D partnership allows the company to add 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.

Lastly, 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 the rental expense is paid out.

Financial ratios are used to analyze a company’s financial standing. OBS financing affects leverage ratios such as 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 debt ratios, other OBS financing situations include operating leases and sale-leaseback impact liquidity ratios. Sale-leaseback is a situation where a company sells a large asset, usually a fixed asset such as 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.

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 keywords that may signal the use of OBS financing. Some of those keywords 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.