Off-Balance Sheet Financing (OBSF)
Candlefocus EditorIn general, off-balance sheet financing is not illegal as long as firms are abiding by accounting rules and regulations. However, financial regulators have become more aware of OBSF and have become stricter in their monitoring and reporting requirements of certain controversial operating leases. This has resulted in more stringent reporting rules, which give greater transparency to the use of OBSF and help to prevent wrongdoing.
There are a few different types of off-balance sheet financing techniques companies use. These techniques include operating leases, trust preferred securities, special purpose vehicles (SPV), securitization, asset exchanges, and short-term financing. Operating leases are one of the most commonly used off-balance sheet financing techniques. A company can enter into an operating lease agreement when it purchases a long-term asset from a supplier but does not want to or cannot immediately place the full cost of the asset on its balance sheet. Instead, the company will enter into a lease agreement with the supplier and gradually pay off the asset over the duration of the lease.
In addition to operating leases, trust preferred securities, special purpose vehicles, securitization, asset exchanges, and short-term financing are also common off-balance sheet financing techniques. Trust preferred securities are hybrid securities that are often used to raise capital in the form of debt financing. Special purpose vehicles are separate entities created by companies to finance specific activities, such as a project or well. Securitization is a financing technique that involves pooling together assets, such as mortgages or auto loans, and selling them in the secondary market as securities. Asset exchanges involve transferring ownership of assets from one business to another. Lastly, short-term financing is used to obtain funds for a reasonably brief time, such as an invoice or business line of credit.
There are a number of benefits associated with off-balance sheet financing. By using OBSF, a company can keep its debt-to-equity ratio and leverage ratio low, which can enable it to receive better financing and prevent debt-to-equity covenant breaches. Lower borrowing costs can also be obtained when using off-balance sheet financing. Furthermore, a company can potentially increase liquidity by using OBSF. This increased liquidity can be used to fund growth, acquire other businesses and make new investments.
Overall, off-balance sheet financing is a useful accounting tool that allows companies to keep certain assets and liabilities off their balance sheets. This allows them to receive cheaper financing and avoid breaching debt-to-equity covenants. Despite the advantages, financial regulators are more aware of OBSF and have become stricter in monitoring and reporting requirements. Companies should therefore be aware of their reporting rules and always comply with all applicable regulations.