Understanding Off-Balance Sheet (OBS) Financing

Balance sheets are important financial statements that help investors and analysts understand a company’s financial position. This document reports a company’s assets, liabilities, and shareholder equity. At times, companies may use accounting practices that involve leaving assets and liabilities off their balance sheets, which keeps certain financial and leverage ratios low. This is called off-balance sheet financing, which we explore in depth below.

Key Takeaways

• Off-balance sheet financing is a legal accounting method, if all the rules are followed, that keeps assets and liabilities off a company’s balance sheet.
• Companies are required to disclose their OBS financing activities in the footnotes of their financial statements.
• Highly leveraged companies use OBS financing to appear more attractive to lenders and investors.
• Investors should look for keywords like operating leases and partnerships in financial statement footnotes, which indicate a company uses OBS financing.

What Is Off-Balance Sheet Financing (OBS)?

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. It is completely legal when the rules are followed, although the practice has been denigrated by some since it was exposed as a key strategy of the ill-fated and fraudulent company Enron which did not do things legally.

Companies might use OBS to reduce their liabilities on the balance sheet to seem more appealing to investors. The problem that investors encounter when analyzing a company’s financial statements is that the disclosures of off-balance sheet financing agreements may not be clear or evident to many readers. Furthermore, some companies may violate the rules and not disclose them at all.

Companies that engage in OBS financing activities must follow reporting guidelines. But, these disclosures may not adequately reflect the company’s total debt. Since disclosures may not completely reveal a company’s total debt, investors must ensure they fully understand the reported statements, and what may be left out, before investing.

Why Is Off-Balance Sheet (OBS) Financing Attractive?

OBS financing is particularly attractive to companies that are highly leveraged. For a company with high debt-to-equity, increasing its debt may be problematic for several reasons:

• Borrowing (more) money is typically more expensive for companies with high debt levels than for those with little debt because the interest charged by the lender is higher.
• Borrowing may increase a company’s leverage ratios causing agreements (called covenants) between the borrower and lender to be violated.

Partnerships, such as those for research and development (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 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.

Finally, 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.

How Off-Balance Sheet (OBS) Financing Affects Investors

Financial ratios are used to analyze a company’s financial standing. OBS financing affects 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. 

Other OBS financing situations like operating leases and sale-leaseback impact liquidity ratios. Sale-leaseback involves selling a large asset (usually a building or large capital equipment) and leasing it back from the purchaser. These 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.

Note

Although the debt-to-equity (D/E) ratio includes short-term debt, it may be excluded when used in a company’s day-to-day operations to more accurately depict a company’s financial strength.

Examples of Off-Balance Sheet (OBS) Financing

Operating leases and partnerships are two common forms of OBS financing, which we explore a little more in depth below.

Operating Leases

Operating leases have been widely used, although accounting rules have restricted their frequency. A company can either rent or lease a piece of equipment and buy it at the end of the lease period for a minimal amount of money, or it can buy the equipment outright.

As of 2016, companies must record operating leases on their balance sheet. This is done by accounting for a lease liability and an asset right-of-use for leases that exceed 12 months. For those less than 12 months, companies can note it as an expense using the straight-line method.

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

Partnerships are another common financing item. 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. Energy, commodities, and services company Enron hid its liabilities by creating partnerships, which led to one of the largest corporate scandals in history. 

Do Companies Have to Disclose Their Off-Balance Sheet Financing Activities?

Yes, companies are required to disclose their off-balance sheet financing activities. While certain assets and liabilities aren’t reported on financial sheets, they must be mentioned in the notes of these documents. Keywords like partnerships, rent/rental expenses, and/or lease expenses often indicate that a company is using OBS financing.

What Advantages Come With OBS Financing?

Off-balance sheet financing is an accounting practice that allows companies to keep certain assets and liabilities off their books. It is completely legal as long as companies adhere to reporting and disclosure requirements. Businesses that engage in OBS financing can access additional and cheaper credit facilities because they appear to be in better shape as financial and leverage ratios appear to be lower.

Are There Any Disadvantages to OBS Financing?

Off-sheet balancing financing is an accounting activity that involves leaving certain assets and liabilities off the balance sheet. It may help them access the financing they need to fund their growth. But, there are certain drawbacks. This practice can mislead investors and lenders into believing that the company is in better financial shape. It can also be difficult for those interested in the company to identify what (types of) items are left off the balance sheet because they appear in the notes of a company’s financial statements.

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 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.