What it means
A balance sheet is the statement that lists what a company owns and what it owes at a point in time. Off-balance-sheet financing uses structures that keep certain obligations out of the main figures, often by placing them in a separate legal entity or in a contract that is classed differently.
The company gets the use of the asset without recording the full debt. Common methods include joint ventures, special purpose entities (separate companies created for a single narrow aim), guarantees, sales of receivables with no recourse, and some types of lease.
Accounting rules have tightened over the years, and most long leases now have to be shown on the balance sheet. Even so, some structures remain legitimate, and others sit in the notes to the accounts instead of the main statement.
Companies use these arrangements for several reasons. They may want to protect a borrowing limit set by lenders, keep leverage ratios (measures of debt compared with equity) looking healthy, or isolate the risk of a project in its own entity.
Used openly, this can be sensible financial planning. The danger is that it can also hide real risk from investors and lenders.
If the separate entity fails or a guarantee is called, the company may have to pay after all. For this reason, careful analysts read the notes to the financial statements and add back the hidden obligations to see the adjusted picture.
For a manager, the key point is that a low debt figure on the balance sheet does not always mean low commitments. Always ask what the company has guaranteed, leased or placed in affiliates.
The acronym OBSF is also written OBS financing in many reports. Regulators and standard setters have narrowed the gap over time.
Rules on consolidation now require a company to include entities it controls, and lease accounting rules bring most long-term rentals onto the balance sheet. The practical effect is that the old tricks work less well, but new structures keep appearing, so careful reading of the notes remains essential.
In practice
Real-world examples.
Example
A property developer places a new office tower in a joint venture that it owns 50% of. The venture borrows $60,000,000 from a bank, and the developer does not record that loan in full. An analyst reading the notes adds the developer's share of the debt to judge its risk.
Example
A retailer sells its trade receivables to a finance company without recourse, receiving $5,000,000 in cash. The receivables leave the balance sheet and the retailer reports lower borrowing. The lender asks how often the practice is used before offering a new credit line.
Example
An airline guarantees the loan of an affiliate that buys aircraft. The guarantee does not appear as debt, but the notes show a $30,000,000 commitment. A credit rating agency includes the guarantee when setting the airline's rating.
Formula
Calculation
Adjusted debt-to-equity = (reported debt + off-balance-sheet obligations) / shareholders' equity
A company reports debt of $20,000,000 and shareholders' equity of $25,000,000. Its notes disclose $10,000,000 of guarantees and other off-balance-sheet obligations. Reported debt-to-equity = 20,000,000 / 25,000,000 = 0.8. Adjusted debt-to-equity = (20,000,000 + 10,000,000) / 25,000,000 = 30,000,000 / 25,000,000 = 1.2, so the true leverage is 50% higher than the reported figure suggests.Case study
Seen in the real world.
Redstone Energy is a fictional power company used to illustrate off-balance-sheet financing. In this illustrative story, it built a new plant through a separate project company and guaranteed $40,000,000 of that company's loan. The main balance sheet showed debt of $50,000,000 against equity of $50,000,000, a ratio of 1.0.
An investor reading the notes added the guarantee to reach adjusted debt of $90,000,000, giving an adjusted ratio of 90,000,000 / 50,000,000 = 1.8. Redstone's lenders took the same view and asked for a larger interest margin on a new loan. Management responded by publishing a clear table of all guarantees in its annual report, which restored confidence. The company also agreed to report its adjusted debt ratio to lenders each quarter, which made later borrowing talks much simpler.
Watch out
Common mistakes.
- Assuming off-balance-sheet financing is always improper. Many structures are legal and disclosed, and the problem arises only when they are used to hide risk.
- Reading only the main balance sheet. Many commitments are found only in the notes, so skipping them gives a falsely comfortable picture.
- Believing the debt has disappeared. The obligation still exists, and the company may have to pay if the other party cannot.
Questions
People also ask.
Is OBSF illegal?
No. It is legal when it follows accounting rules and is properly disclosed, but it can be abused.
Where do I find these obligations?
Look in the notes to the financial statements, in sections on commitments, contingencies, leases and related parties.
Why do lenders care?
They want to know the full set of claims on the company's cash flow before they agree to lend more.
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