Types of Off-Balance-Sheet Financing

Many economic transactions and events are not recognized in the financial statements because they do not qualify as accounting assets or transactions under GAAP standards. But these unreported assets and liabilities have real cash flow consequences.

Operating lease
Classifying a lease as an operating lease provides a company with the opportunity to utilize the leased asset and assume a contractual obligation to pay the lessor during a specific period of time without having to report the asset and the liability.

Impact:
· Reduces assets and liabilities. Boosts leverage (debt/equity), profitability (ROA), and Activity (Sales/Assets) ratios.

Take-or-pay contract
Buyer commits to purchase a minimum quantity of input over a specified time period. Buyer effectively receives the use of a productive asset without reporting it on its balance sheet. Disclosure rules require firms to report the minimum future payments.

To reflect economic reality of TOP contracts an analyst should add the PV of the minimum payments to both the assets and liabilities. This increases leverage and reduces asset turnover.

Throughput arrangements
Natural-gas companies use throughput arrangements with pipelines or processors to ensure distribution or processing. The effects are the same as take-or-pay contracts.

Commodity-linked bonds
Natural-resource companies may also finance inventory purchases through commodity-indexed debt where interest and/or principal repayments are a function of the price of the underling commodity.

The sale of accounts receivables
A company may sell its receivables to an unrelated third party to reduce its debt and improve its financial position. Most sales of receivables provide the buyer with a limited recourse to the seller. However, the recourse provision is generally well above the expected loss ratio on the receivables (allowance for doubtful accounts). The potential liability associated with the buyer-recourse provision is not displayed on the balance sheet.

Sale of receivables no-recourse basis:
· Truly removed from balance sheet.

Sale of receivables limited recourse basis:
· Firms recorded them by reducing AR and increasing CFO. The seller is exposed to the collecting risk and so economically they are just collateralized loans.

To reflect economic reality of sale of receivables limited recourse basis, an analyst should:
· Add back sold receivables to AR and create a current liability equal to the proceeds of sale.
· Subtract sold receivables from CFO and CFF.
· Increase revenues and interest expense by effective interest paid on the transaction.

These adjustments reduce the current ratio, increase the leverage and reduce the interest coverage.

Financing subsidiaries:
Not consolidated in parent company’s accounts if ownership is less than 50%. Firms often manipulate accounts by shifting their assets and liabilities out to subsidiaries

Analyst should add back proportionate share of the asset or liab for debt-to-equity ratio, receivable turnover, interest coverage ratio.

Joint ventures:
May create obligations for parent firms if any direct or indirect guarantees are given to secure financing.

Analyst should add guaranteed debt or proportionate non-guranteed share of debt