It’s a form of financing used to fund assets that do not have to be shown in the balance sheet.
And the next question, is why? Well, the nature of the financing is such that the total liability doesn’t have to be recorded on the balance sheet thereby making the balance sheet look better.
Of course the asset is also off the balance sheet but if a business already has large borrowings on its balance sheet, it can be advantageous not to overload it. So when ratios and loan covenants are worked out, off-balance sheet financing has its advantages.
The most common form of such funding today are operating leases for equipment and short-term property leases. Operating leases are used by most businesses for equipment, vehicles and IT kit which are usually short-term leases over 2-5 years. As technology changes rapidly, some larger more expensive equipment items are also now being offered by financiers on operating leases.
Even my iPhone 5 is now leased! Since the asset is not owned by the business, it does not have to be recorded on the balance sheet – so no asset or liability! Only the monthly rental costs are charged to the Profit & Loss Account as these are incurred.
There are 3 major advantages to operating leases:
1. Keep up to date with rapid technological change – businesses can keep up to date and upgrade equipment.
2. Operating leases can be cheaper – this is because the lessor will build in a residual value for taking your old asset away and selling it second-hand.
3. Cash flows are better – businesses don’t have to stump up upfront cash amounts to buy equipment and the monthly rentals help cashflows.
So what are the dangers of off-balance sheet financing? The best example was Enron – that was due to all forms of off-balance sheet items that eventually brought it down. Of course today, that’s a lot more difficult since other lenders will always find out what off-balance sheet liabilities a business has.
The best way to find out what is hiding from the balance sheet is to read the notes to the balance sheet and look for a title called ‘lease and rental commitments’ or something similar. Accounting rules dictate the companies have to declare total leasing commitments in the notes so such liabilities cannot be hidden.