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Off balance sheet financing is used by many businesses as an accounting tool and for raising additional capital from investors.
Through off balance sheet financing, both international and domestic companies can gain capital while keeping certain financial ratios, such as debt-to-equity and leverage ratios, low.
This article will look at what off balance sheet financing is, examples of off balance sheet financing, items and some of the pros and cons of using it.
|Table of contents
Off balance sheet financing is defined as the practice of not including certain assets or liabilities on a company’s balance sheet.¹
Off balance sheet financing is also sometimes referred to as ‘incognito leverage’, as businesses can use the off balance sheet items as a type of leverage and show a company’s liquidity.²
Both international and domestic companies use off balance sheet financing for a variety of reasons depending on business goals.
Some companies use it as an accounting tool to keep their debt-to-equity ratio low; others use it as a financial performance indicator, so it can vary.
Through off balance sheet financing, companies can keep their debt under a certain amount by not showing significant capital expenditure on the balance sheet.
Using OBSF, companies can demonstrate whether the company is liquid without creating a negative overview of the company’s financial performance.
However, companies must disclose off balance sheet items to ensure transparency, especially if they might pose a liability or threat to business operations.
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Now that there is a definition of off balance sheet financing, the next question is whether it is legal or not.
Off balance sheet financing is legal and is a widely used accounting tool by many companies. However, it does come with significant requirements and obligations.
If the items left off the balance sheet could significantly impact its financial position and normal operation, it must be disclosed.³
The U.S. Securities and Exchange Commission (SEC) has additional disclosure guidelines for off balance sheet financing, saying that the disclosure should include:
'The nature and business purpose of the off-balance sheet arrangement';
'The importance to the registrant of the off-balance sheet arrangement to their liquidity, capital resources, market risk support, credit risk support or other benefits';
'The amounts of revenues, expenses and cash flows of the registrant arising from such arrangements; the nature and amounts of any retained interests, securities issued and other indebtedness incurred in connection with such arrangements; the nature and amounts of other obligations or liabilities of the registrant that are or are reasonably likely to become material and the triggering events that could cause them to arise';
'Any known event, demand, commitment, trend or uncertainty that will result in or is reasonably likely to result in the termination or material reduction in availability to the registrant of the off-balance sheet arrangements that provide material benefits, and the course of action that they have taken or propose to take in such circumstances.’
With off balance sheet items, disclosure is an essential part of the process to ensure that financial reporting is clear and transparent.
In addition, there are legal entities who monitor accounting practices to ensure that businesses communicate transparent and honest financial information.
Entities include the:
- Financial Accounting Standards Board (FASB and
- International Accounting Standards Board (IASB), which are private and independent standard-setting bodies that monitor account standards.
- It’s important to mention the Generally Accepted Accounting Principles (GAAP) as well, which is accepted by the SEC.³
Off balance sheet financing must be done with careful attention to ensure that the business is appropriately and transparently communicating its financial health.
As an example, let’s take airline companies and how they use off balance sheet financing.⁴
Many airlines owned their airplanes in the past, which meant they had significant assets that they must report on their balance sheet.
If a large amount of capital, such as a loan, was used to purchase the airplanes, that would also be included on the balance sheet.
That would increase the airline company’s debt-to-equity ratio and could potentially make it look less attractive to investors and creditors.
However, airline companies have since changed that arrangement.
Instead, most airlines lease planes, working together with leasing companies and keep that arrangement off the balance sheet.
That way, airlines don’t need to borrow as much to meet their financial obligations to the leasing companies and reduce the debt owed.
While that could look attractive to investors and creditors right off the bat, it could also negatively impact the airline company.
Not owning their airplanes means that the company has significantly fewer assets.
In turn, this could signal that the company could have trouble raising money down the line if needed since they could not sell off any airplanes to gain capital.
There are a few different items that are used in off balance sheet financing, such as:
- Letters of credit
- Loan commitments
- Revolving underwriting facilities, i.e., types of funding methods if borrowers are unable to raise funds elsewhere
Letters of credit refer to contractual obligations between banks, importers, and exporters and are used in international trade.
The letter essentially serves as a guarantee that sellers will receive the full amount of the buyer’s payment by a specific date.
The letter of credit is a protective measure and is extremely beneficial, as exports receive a guarantee of payment and can offer importers better payment terms.⁵
Until the letter is used, it does not need to be presented on the balance sheet, which is why it is disclosed as an off balance sheet item.⁷
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Loan commitments refer to any written agreements between the company (i.e., the borrower) and the bank.
The commitment will detail terms and conditions under which the bank will provide a loan to the company, including the funding limit and expiration date.
The borrower may also need to deposit a fee to secure the conditions of the loan. Because the agreement is a loan commitment, but it has not started yet, loan commitments can be included as an off balance sheet item.⁶
A revolving underwriting facility (RUF) is an agreement between banks and borrowers to purchase short-term notes at a fixed spread and interest rate.
The agreement is made if the borrower cannot sell the short-term notes in the market at or below the rate determined.
The agreement is made because the borrower anticipates selling the notes for additional funding, but if they cannot, the credit will be available under RUF with the stipulations.⁶
|✔ Off balance sheet financing Pros
Off balance sheet financing can have significant advantages for companies seeking additional funding and investment.
It doesn't affect the company’s debt burden, making its debt-to-equity ratio more suitable for creditors and investors.
Additionally, off balance sheet financing does not affect how a company’s financial performance is viewed, making it more beneficial for businesses.
Because the items on the off balance sheet financing are commitments with external parties, they don't pose a risk for the business.
Therefore, until there are transactions associated with the agreements, businesses do not need to report them on the balance sheet.
|❌ Off balance sheet financing Cons
The cons of off balance sheet financing mostly relate to honesty and transparency in business communication. If misused, it can be misleading and increase the risk for the business due to ethical concerns.
If companies hide liabilities that could significantly impact the business, investors and creditors will not look favorably upon that.
That’s why disclosure is crucial when using accounting tools such as off balance sheet financing, as investors and creditors must have a full picture of assets and liabilities for their decision-making.
Off balance sheet financing can be complex, but it’s just one aspect of financial reporting.
You can build up a complete overview of how your business is performing across different indicators using financial statement templates.
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- Oxford Reference - Off-balance sheet
- FINcyclopedia - Incognito Leverage
- SEC gov. - Financial Reporting Manual
- The New York Times - Chills in the Balance-Sheet Shadows
- Trade.gov - Letter of Credit
- FDIC gov. - Section 3.8 Off-Balance Sheet Activities
- Federal Reserve. gov Off-Balance Sheet Items of Depository Institutions in the Enhanced Financial Accounts
All sources checked 27 December 2021
This publication is provided for general information purposes and does not constitute legal, tax or other professional advice from Wise Payments Limited or its subsidiaries and its affiliates, and it is not intended as a substitute for obtaining advice from a financial advisor or any other professional.
We make no representations, warranties or guarantees, whether expressed or implied, that the content in the publication is accurate, complete or up to date.
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