Off Balance Sheet Financing Case Study
For example, let's assume that Company XYZ has a $4,000,000 line of credit with Bank ABC. The line of credit comes with a financial covenant that requires Company XYZ to stay below a 0.5 debt-to-equity ratio at all times. Company XYZ wants to buy a new widget-making machine, which costs $1,000,000, but it does not have the cash to make the purchase. If it takes on more debt, it will violate the debt-to-equity covenant on its line of credit. Therefore, Company XYZ needs to find another way to obtain a widget-making machine.
To solve the problem, Company XYZ creates a separate entity that will purchase the widget-making machine and then lease it to Company XYZ (this is called an operating lease). This way, even though Company XYZ has virtually complete control of and responsibility for the widget-making machine, it only has to record its monthly lease expense on its income statement; it does not have to record the additional debt on its balance sheet, and it does not record an increase in assets (because it does not legally own the widget-making machine). Thus, it is able to acquire an asset without having to record the transaction as such on its balance sheet.
Besides operating leases, other examples of off-balance-sheet financing include selling receivables under certain conditions, providing guarantees or letters of credit, or participating in joint ventures or research and development activities. Often, companies purchase small ownership positions in special purpose vehicles (SPVs) or special purpose entities (SPEs) that have their own balance sheets, and companies then place the assets or liabilities in question on the SPEs' balance sheets. These SPE's might have higher credit ratings than sponsoring firms that created them, which helps them obtain cheaper financing.
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.