Off-balance sheet financing

Off-balance sheet (OBS), or incognito leverage, usually means an asset or debt or financing activity not on the company’s balance sheet. Total return swaps are an example of an off-balance sheet item.

Some companies may have significant amounts of off-balance sheet assets and liabilities. For example, financial institutions often offer asset management or brokerage services to their clients. The assets managed or brokered as part of these offered services (often securities) usually belong to the individual clients directly or in trust, although the company provides management, depository or other services to the client. The company itself has no direct claim to the assets, so it does not record them on its balance sheet (they are off-balance sheet assets), while it usually has some basic fiduciary duties with respect to the client. Financial institutions may report off-balance sheet items in their accounting statements formally, and may also refer to “assets under management”, a figure that may include on and off-balance sheet items.

Differences between on- and off-balance sheets

Traditionally, banks lend to borrowers under tight lending standards, keep loans on their balance sheets and retain credit risk the risk that borrowers will default (be unable to repay interest and principal as specified in the loan contract). In contrast, securitization enables banks to remove loans from balance sheets and transfer the credit risk associated with those loans. Therefore, two types of items are of interest: on-balance sheet and off-balance sheet. The former is represented by traditional loans, since banks indicate loans on the asset side of their balance sheets. However, securitized loans are represented off the balance sheet, because securitization involves selling the loans to a third party (the loan originator and the borrower being the first two parties). Banks disclose details of securitized assets only in notes to their financial statements.

Leasing:

It is the oldest form of off-balance-sheet financing. Leasing an asset, allows the company to avoid showing financing of the asset from its liabilities and lease or rent is directly shown as an expense in the Profit & Loss statement.

Special Purpose Vehicle (SPV)

Special purpose vehicles or subsidiary companies are one of the routine ways of creating off the balance sheet financing exposures. It was used by Enron, which is known for one of the high profile off-balance-sheet financing exposure controversies.

Hire Purchase Agreements

If a company cannot afford to purchase assets outright or obtain finance for the same, it can enter into a hire purchase agreement for a certain period with financiers. A financier will purchase the asset for the company, which in turn will pay a fixed amount monthly until all the terms in the contract are fulfilled. The hirer has the option of owning the asset at the end of the hire purchase agreement.

Factoring

It is a type of credit service offered by Banks and other financial institutions to their existing clients. Under factoring, finance is obtained by selling account receivables to Banks. Banks offer immediate cash to the company after taking some cut from account receivables  for offering the service.

Purpose:

• Better solvency ratios ensure maintaining a good credit rating, which in term allows the company to access cheaper finance.
• To maintain solvency ratio like Debt-to-equity ratio below a certain level and obtain funding which company would not have been able to obtain otherwise.
• It makes balance sheet finance appear leaner, which prima facie may attract investors.

Key Features

• There is a change in the Capital structure of the company.
• It results in the reduction in existing assets or exclusion of assets going to be created from the balance sheet.
• It involves the use of creative accounting and financial instruments to achieve off-balance sheet finance.
• Assets and liabilities are both understated, and it gives a leaner impression of the balance sheet finance.