The term off-balance-sheet financing refers to arrangements that do not appear as a liability on the balance sheet of a company. Examples of off-balance-sheet financing include research and development arrangements, operating leases, and project financing.
Also referred to as incognito leverage, off-balance-sheet financing is a technique companies can use to keep its debt to equity ratio low. By entering into arrangements that suppress the company’s actual use or need for debt, its financial stability and creditworthiness is overstated by rating agencies. The company may also have a loan covenant that imposes a limit on the amount of debt it can carry. The abuse of this technique is often connected with the Enron bankruptcy proceeding.
The most common forms of off-balance-sheet financing include:
- Operating Leases: occurs when a company enters into a leasing arrangement rather than purchasing an asset. The Financial Accounting Standards Board has set forth rules outlining the difference between capital and operating leases.
- Research and Development Arrangements: if an R&D company is in need of cash, it can enter into a limited partnership with an investor. If the risks associated with the R&D effort are assumed by this limited partnership, the related expense and debt do not need to appear on the research and development company’s books.
- Project Financing: two or more parties form an entity that will build an asset to be shared by all parties. The newly formed entity then borrows the money needed to construct the asset, and uses the proceeds generated by the asset to repay the debt.