Understanding the Risks of Off-Balance Sheet Financing

Off-balance-sheet financing is a procedure that many companies use from time to time. This is basically an accounting procedure that can be done for a variety of reasons. Although it originally started out as a legitimate business practice, it has taken a lot of negative heat in recent years. Here are the basics of off-balance-sheet financing and how it can hurt a company.

Off-Balance-Sheet Financing

This is a method that is used by companies in order to keep large expenditures off of the company balance sheet. This is done by setting up a separate legal entity as either a spin off of the existing company or a partnership. The company will set up the legal entity and then transfer assets or debts to it. This is done so that it will not affect the parent company financially.

Why Companies Use It

There are a variety of reasons that a company could turn to off-balance-sheet financing. Originally, many companies used this method in order to pursue new business opportunities without disrupting their current businesses. By using this strategy, they could keep from altering the share prices of their stock and confusing existing investors. For example, let's say that a business wanted to branch out into another area besides what their current business already covers. Instead of just making a large investment under the name of their existing company, they could start a separate legal entity and bring on private investors for that entity. These investors might be interested in investing only in the separate project instead of the parent company itself. By doing this, the parent company will still be in charge of the operations of the separate legal entity, but none of the financial transactions will show up on the parent company's balance sheet.

Getting around Covenants

Although this strategy does have some merit in certain cases, it can definitely be used the wrong way. For example, some companies will utilize the strategy in order to get around covenants that were designed to help keep the company out of too much debt. If a company wants to make a large purchase but is prevented from doing so by the company bylaws, they can simply create another legal entity to do it for them. This allows them to get around the rules and take on extra debt.

Cover up Mistakes

Some companies have also used this method to cover up mistakes that they have made in the course of business. The most popular example of this happening was with the Enron scandal. A company can use off-balance-sheet financing to hide poor investment decisions by transferring them to a separate legal entity. Companies can use this method to boost their financial earnings and profit numbers for the sake of investors.

Bad Perception

Since Enron, investors have a bad perception about off-balance-sheet financing. If a company chooses to use this method, even for honest reasons, it can negatively affect the stock price in the market. This has discouraged many companies from using these methods since then.