Off-balance-sheet financing (OBSF) is an alternative method of business financing that may be used in specific situations where traditional bank financing isn’t an option. Off-balance-sheet financing refers to a practice where a company obtains funding or assets without recording them as liabilities on its balance sheet. This approach allows businesses to manage their financial obligations and present a more favorable financial picture to shareholders and anyone else with a vested interest. 

Benefits of Off-Balance-Sheet Financing

• Maintaining Healthy Debt-to-Equity Ratios

Unlike a regular bank loan, off-balance-sheet financing effectively allows companies to finance projects without having those funds show up as a debt nor liability in their books, this being the primary appeal in utilizing it. Whilst this type of funding may be used to ‘mask’ long-term debt, it’s still a perfectly acceptable accounting method and a way for businesses’ to invest into projects that support their growth without impacting ratios such as debt-to-equity; how much debt a company has compared to its assets. 

A good debt-to-equity ratio is a crucial indicator of a business’ ability to cover its liabilities and is often used by potential investors looking at the capital structure of a company and by financial institutions during the underwriting process. A lower debt-to-equity ratio can make a company appear more financially stable and therefore, a more attractive proposition for investors. 

• Enhanced Creditworthiness

Just as investors will look for a healthy debt-to-equity ratio, financial institutions will use it as a key indicator of a company’s ability to repay on a loan. By keeping certain liabilities off the balance sheet, companies can present a more favorable debt profile to lenders. This may result in easier access to credit or better borrowing terms such as lower interest rates or reduced collateral requirements. 

• Flexibility in Managing Financial Resources

OBSF can offer businesses a greater flexibility in managing their financial resources. Although off-sheet items will usually be noted somewhere, not explicitly showing the debt and associated risk on the balance sheet enables them a level of adaptability in undertaking new projects, making investments or pursuing joint ventures and partnerships which require shared risks and rewards.

• Improved Liquidity and Cash Flow

Businesses may use off-balance-sheet financing to access additional liquidity without directly impacting their balance sheet. This can be particularly beneficial when they require funds for expansion, research and development or other strategic initiatives. They may also want to leave their existing credit-lines untouched so as to be able to react quickly to market conditions and unpredictable events without threatening their financial stability.  

Closely related to liquidity is the flexibility that can be achieved with capital expenditure; OBSF allows companies to lease or rent assets rather than purchasing them outright. This can negate large capital outlays and preserve cash for other investments or operational needs. 

• Reduced Financial Risk

Off-balance-sheet financing can limit exposure to specific risks. By transferring certain risks associated with assets or liabilities to another entity, the business can mitigate potential losses and protect its financial position. This can be particularly valuable when dealing with volatile assets such as derivatives or certain lease agreements. 

One such example of reducing risk could be in a leaseback arrangement where the business can transfer the risk of owned asset depreciation or obsolescence to the buyer or lessor. By doing so, the company reduces its exposure to potential losses related to those assets. 

• Regulatory Advantages

In some cases, off-balance-sheet financing can help companies comply with regulatory requirements. For example, lease agreements structured as operating leases rather than capital leases may enable companies to avoid recording large lease obligations on their balance sheets under certain accounting standards.

What Types of Finance Can be Treated as Off-Balance-Sheet?

Operating leases, leaseback agreements and accounts receivable financing are three main items that may be structured as off-balance-sheet finance, each with their own complexities. 

Operating Leases

A common method of achieving off-balance-sheet treatment for equipment financing is through operating leases. In an operating lease, the lessor (the equipment owner) retains ownership of the equipment while leasing it to the lessee (the business). The lease payments are treated as operating expenses rather than debt, allowing the lessee to keep the equipment and related lease obligations off their balance sheet. 

Some of the key characteristics of an operating lease are…

• They are typically a non-cancellable agreement for a shorter duration compared to the useful life of the equipment. It allows the lessee to use the equipment for a defined period without assuming the risks and rewards of ownership. 
• The equipment owner retains ownership of the equipment throughout the lease terms and the lessee does not usually have the option to purchase the equipment at the end of the lease. 
• The equipment owner is responsible for maintaining and servicing the equipment, relieving the lessee from the time and cost of these obligations. 
• An operating lease is structured in such a way that allows the lessee to keep the lease obligations and underlying equipment off their balance sheet as they are considered operating expenses. 

It’s worth noting that accounting standards such as the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP), have specific criteria for determining whether a lease qualifies as an operating lease or a finance lease (capital lease). If the lease fails to meet the criteria for an operating lease, it may be classified as a finance lease, resulting in it having to be recognized on the balance sheet as such. 

Companies often choose operating leases for equipment finance, vehicles or machinery because it provides flexibility, preserves capital and avoids showing large liabilities on their balance sheets. However, it’s essential to carefully assess the legal accounting requirements for the jurisdiction you’re in when considering OBS finance and operating leases.

Leaseback Agreements

A leaseback agreement shares some similarities with an operational lease but this involves a transaction where a company sells an asset to a buyer and immediately leases the same asset back from the buyer. In a leaseback agreement, also known as a sale and leaseback arrangement, the lessee (the business) becomes a user of the asset, while the buyer (the lessor) becomes the owner of the asset. While an operational lease can be structured as an off-balance-sheet arrangement, not all operational leases qualify as leaseback agreements. Leaseback agreements specifically involve the sale of an asset followed by the leaseback, creating a continuous relationship between the original owner and the asset. 

The seller receives immediate cash by selling the asset and the buyer acquires ownership of the asset. The terms of the lease, including rental payments, duration and other conditions, are typically negotiated separately from the sale of the transaction. 

Leaseback agreements have very definitive characteristics and considerations across legal, financial and accounting implications which distinguish them from operational leases. Financial professionals will be able to assess these implications and advise on the proper structure of a leaseback agreement for your particular situation. 

Accounts Receivable Finance

Invoice factoring can be structured in such a way that allows it to be treated as an off-balance-sheet transaction. Some of the ways this may be achieved are;

• The key concept in off-balance-sheet invoice factoring is the ‘true sale’ of invoices. In a true sale arrangement, the business selling the invoices transfers ownership of the invoices to the factoring company. This transfer removes the invoices from the seller’s balance sheet because they are no longer considered the seller’s assets. 
• Non-recourse factoring is another method used to keep the transaction off the balance sheet. In this arrangement, the factoring company assumes the credit risk associated with the invoices. If the debtor fails to pay, the factoring company cannot seek reimbursement from the business that sold the invoices; further removing financial liability from the seller’s balance sheet. 
• To maintain off-balance-sheet treatment of invoices, the business selling them should not retain any control or continuing involvement over the invoices. This means that the factoring company takes responsibility for collecting the payments and managing receivables. The seller should not have the ability to reacquire or substitute the invoices at a later time. 
• While off-balance-sheet factoring removes the invoices from the seller’s balance sheet, it doesn’t mean that they go completely unrecorded. GAAP require disclosure of OBS arrangements in the footnotes of supplementary schedules to the financial statements. This ensures transparency and provides relevant information to all users of financial statements.  

Find Out if Off-Balance-Sheet Lending is Right for You

Off-balance-sheet financing can certainly serve an important strategic purpose for many businesses. It also comes with potential risks and complexities. It requires careful structuring, thorough risk assessment and compliance with accounting standards and regulatory guidelines to ensure transparency and accurate financial reporting. 

Regulations and standards vary across jurisdictions and as with any financing decision, if you’re unsure whether this type of funding would best suited to your needs or how to determine the appropriate accounting treatment, you should seek the advice of a professional business accountant in your region.

Sallyport’s success depends on the success of our clients – we’re always on hand to talk openly and transparently about off-balance-sheet financing and its role in helping you achieve your goals in business. Reach out today for further details.