What it is:
How it works (Example):
For example, let's assume that Company XYZ has a $4,000,000 line of credit with Bank ABC. The line of credit comes with a financial covenant that requires Company XYZ to stay below a 0.5 debt-to-equity ratio at all times. Company XYZ wants to buy a new widget-making machine, which costs $1,000,000, but it does not have the cash to make the purchase. If it takes on more debt, it will violate the debt-to-equity covenant on its line of credit. Therefore, Company XYZ needs to find another way to obtain a widget-making machine.
To solve the problem, Company XYZ creates a separate entity that will purchase the widget-making machine and then lease it to Company XYZ (this is called an operating lease). This way, even though Company XYZ has virtually complete control of and responsibility for the widget-making machine, it only has to record its monthly lease expense on its income statement; it does not have to record the additional debt on its balance sheet, and it does not record an increase in assets (because it does not legally own the widget-making machine). Thus, it is able to acquire an asset without having to record the transaction as such on its balance sheet.
Besides operating leases, other examples of off-balance-sheet financing include selling receivables under certain conditions, providing guarantees or letters of credit, or participating in joint ventures or research and development activities. Often, companies purchase small ownership positions in special purpose vehicles (SPVs) or special purpose entities (SPEs) that have their own balance sheets, and companies then place the assets or liabilities in question on the SPEs' balance sheets. These SPE's might have higher credit ratings than sponsoring firms that created them, which helps them obtain cheaper financing.
Why it Matters:
Off-balance-sheet financing is most often used in order to comply with financial covenants. However, companies also use off-balance-sheet financing to preserve borrowing capacity (for example, when a company is close to hitting its limit on a borrowing line or would like to use its borrowing line for something else), lower their borrowing rates, or manage risk. The strategy, however, has had a bad reputation since it was famously used by former energy giant Enron.
It very important to note that off-balance-sheet financing transactions are not invisible, as many people believe. Rather, the Securities and Exchange Commission (SEC) and generally accepted accounting principles (GAAP) require companies to disclose these and other financing arrangements in the notes to their financial statements. Savvy investors know to look at these notes for information and insight. Additionally, GAAP rules are very particular regarding how to record off-balance-sheet items, and managers who do not know these rules or do not apply these rules properly can face considerable consequences.