Off-balance sheet financing is an accounting strategy that involves excluding certain liabilities from a business’s balance sheet. This can help keep a company’s ratios (like debt-to-equity) low and make it easier to attract an investor or get financing.
Is it legal? Yes, as long as you follow certain rules and regulations. If, on the other hand, you use off-balance-sheet financing to mislead investors, lenders, or regulators about your company’s financial picture, you can get into legal (as well as financial) hot water. Read on to learn how off-balance sheet financing works, as well as its benefits and risks.
What Is Off-Balance Sheet Financing?
Off-balance sheet financing is a way to keep certain debts and liabilities (and sometimes assets) off of a company’s balance sheet. This can lower a company’s debt-to-income and other ratios, and make it look more attractive to lenders and investors.
Another reason why a company might turn to off-balance sheet financing is to make sure their leverage ratios don’t breach agreements they already have with lenders (called covenants) regarding negative debt.
While it may seem potentially shady, off-balance sheet financing is a legal practice, provided you follow rules established by the generally accepted accounting principles (GAAP) and disclose off-balance sheet financing in the footnotes of your financial statements.
How Does Off-Balance-Sheet Financing Work?
Off-balance sheet financing involves financing an asset without adding liabilities to the balance sheet. To accomplish this, a company may move certain assets, liabilities, or transactions away from their balance sheet and onto other entities, such as a subsidiary, special purpose vehicle (SPV), or partner. Doing so can make the company appear more attractive to an investor or allow them to qualify for better rates and terms on a small business loan.
Off-Balance Sheet Item Examples
Here’s an off-balance-sheet financing example: Let’s say Company A is already heavily financed but wants to purchase high-dollar manufacturing equipment. By having one of its subsidiary companies (Company B) make the purchase, the debts and assets remain on Company B’s balance sheet. Even though Company A authorized the purchase and will be the one using the equipment, it will be Company B’s balance sheet and debt-to-income ratio that are affected.
Another way Company A could use off-balance sheet financing is to enter a long-term lease to obtain the equipment. This avoids financing the equipment and adding a new liability to its balance sheet.
Off-Balance Sheet Financing Methods
Here’s a look at some of the ways that companies use off-balance sheet financing.
• Operating lease: With this arrangement, a company rents or leases a piece of equipment instead of buying it outright. At the end of the lease period, the company then purchases that equipment at a low price. This strategy allows a business to only record lease payments as an operating expense on the income statement instead of listing the asset and liability on its balance sheet.
• Leaseback agreement: With a leaseback, a company can sell an asset to another company (usually one it has a financial connection to) and lease it back as needed. This allows them to use the asset yet keep it off its balance sheet.
• Accounts receivables: Companies that have unpaid invoices, can sell them to another company (called a factor company) at a discounted value. This allows the company to avoid recording a large (and possibly uncollectible) asset on its balance sheet. The factor company takes over the responsibility (and risk) of collecting payments from the customers. When the factor company receives payments, they give it to the original company, minus their fee.
• Partnerships: Creating a partnership is another way to improve a company’s balance sheet. By doing this, the business doesn’t have to show the partner company’s liabilities on its balance sheet, even if it has a controlling interest in the company.
• Special purpose vehicles (SPVs): Large companies may create a subsidiary, called an SPV, to reduce their financial risk. Because the SPV has its own balance sheet, the company can move assets or liabilities onto the SPV’s balance sheet. The SPV may also have a higher credit rating, allowing the company to get financing with better rates and terms.
Pros and Cons of Off-Balance Sheet Financing
Off-balance sheet financing can be appealing if your company wants to get different types of business loans that might otherwise be hard to qualify for. However, it also comes with some drawbacks.
Pros
Off-balance sheet financing is technically legal and permissible, so long as you follow all GAAP protocols. In addition, it can help a company get approved for credit when it otherwise would not be able to. If your business is already highly leveraged and wants to move forward with a large capital investment, off-balance sheet financing can make it happen. Likewise, it may help a company acquire additional investors.
Off-balance sheet financing can also happen naturally without any intention to cloud a company’s records. Leases, for example, are a valid strategy to keep a company’s overall debts down while enabling it to continue with its day-to-day operations.
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Cons
There are also a number of disadvantages and risks involved in off-balance sheet financing. For one, the practice is generally frowned upon by both investors and lenders. Even if the business follows every rule in the book, off-balance sheet-financing methods can suggest to outsiders that there is something to hide.
Using off-balance sheet financing can also put your company at risk. After all, things like debt-to-income ratios exist for a reason. When companies take on more debt than they can comfortably handle, they often have no choice but to default on their debts.
| Pros of Off-Balance Sheet Financing | Cons of Off-Balance Sheet Financing |
|---|---|
| May help a company look more attractive to investors | Has contributed to financial collapses (such as Enron’s) |
| Can help a company get approved for financing with competitive rates and terms | Generally frowned upon by investors and lenders |
| Technically a legal practice and accepted by GAAP | Can falsely improve the appearance of a company’s financials |
Reporting Requirements for Off-Balance Sheet Financing
The Securities and Exchange Commission (SEC) requires public companies to list off-balance sheet financing in the notes of all of their financial statements. This provides more transparency to investors.
It’s also important to note that in 2016 the Financial Accounting Standards Board (FASB) changed the rules around lease accounting. Companies are now required to list on their balance sheets any assets and liabilities that are a result of leases greater than 12 months. Businesses must record both finance and operating leases on their balance sheets.
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Is Off-Balance Sheet Financing Legal?
Yes. While off-balance sheet financing is generally frowned upon, it is not illegal as long as a company makes proper notes and records. To police it to the degree that would be needed to stop off-balance sheet financing would make it difficult for businesses to engage in deals like leasing and partnerships.
Enron’s Notorious Off-Balance Sheet Financing Practices
Enron’s demise stands out as one of the most infamous examples of off-balance sheet financing. Enron essentially used SPVs to keep large amounts of debt and losses it had amassed hidden from lenders and investors. The SPVs were reported in the notes on Enron’s financial documents, but not many investors thought to look for them, and those that did failed to fully understand the precariousness of Enron’s situation.
When Enron’s stock started to go down, the value of the SPVs also went down. Because Enron was financially liable for the SPVs, the company became unable to repay its debts and ultimately ended up filing for bankruptcy.
Can You Tell if a Business Is Using Off-Balance Sheet Financing?
Generally, yes. Businesses are required to include information about any off-balance sheet financing in the footnotes of their financial statements. However, you have to know what to look for to fully understand a company’s liabilities.
As an investor, it’s a good idea to review all of a company’s financial statements thoroughly (including the footnotes) and to keep an eye out for keywords that may signal the use of off-balance sheet financing, such as “partnerships”, “rental,” or “lease expenses.” If you see any of those terms, it’s a good idea to investigate further to make sure that these expenses and deals are appropriate.
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The Takeaway
Off-balance sheet financing is a way to make a company’s financial situation seem better than it really is. Nevertheless, it is legal. And certain methods of off-balance sheet financing, like leasing, are common and may be necessary.
The practice of keeping certain assets and liabilities off your balance sheet, however, can be risky. It’s important to know that even if you engage in GAAP-compliant methods of off–balance sheet financing, this strategy can make it harder to get a full and realistic picture of your company’s total financial commitments.
If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.
FAQ
Is off-balance sheet financing illegal?
No. As long as off-balance sheet financing is done in keeping with generally accepted accounting principles (GAAP) rules and is disclosed in the notes of your financial statements, it is legal.
What are considered off-balance sheet items?
Off-balance sheet items include:
• Leaseback agreements
• Operating leases
• Accounts receivables
How are balance sheet and off-balance sheet financing different?
A balance sheet lists a company’s assets, liabilities, and shareholder equity at a specific point in time. On-balance sheet financing is when a business accounts for an asset or liability on the balance sheet. Off-balance sheet financing is when a business leaves an asset or liability off the balance sheet and accounts for it somewhere else.
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