Introduction to Off Balance Sheet Financing
Off-balance sheet financing is one of the ways to finance the business organization indirectly i.e. without showing in the balance sheet to prevent from high debt-equity ratio and to attract the investors by showing clean balance sheet and it indicates there is something wrong in the accounts which company or business organization is trying to hide.
Explanation
Normally if the company takes financing services then it will have to show it in the balance sheet. Financing services include loans and borrowing or equity issue or debentures etc. Off-balance sheet financing is one of the indirect ways of financing so as to get the finance without reflecting it in the balance sheet. It is the smarter way of management but sometimes it creates doubt on the management about chances or fraud or misuse of the funds. Off balance sheet financing is an accounting practice where the company can finance its activities without reflection in the balance sheet in a legal manner. The purpose behind the sheet financing is to keep the faith of investors by showing a low debt equity ratio as direct financing can affect the liabilities of the company as well as its level of debt. There are many way of entering into the sheet financing like entering into a partnership, joint venture, investment in associate companies, entering into lease, etc.
Example of Off-Balance Sheet Financing
A Ltd requires the loan for expanding the business, but A Ltd already taken loan from ABC bank and terms of loan requires to maintain the debt equity ratio to 0.5 which is the current debt equity ratio of A Ltd. if A Ltd. acquires the loan the debt equity ratio will increase. Hence A Ltd invest in the partnership firm where the directors of A Ltd were partners and taken a loan on the name of the partnership and A Ltd. stands as guarantors. And the balance sheet of A Ltd shows the net investment in the partnership. In this way, A Ltd hides the liability of indirect loan thereby maintaining the debt equity ratio as required.
How does It Impact Investors?
It impact the investors in the following ways:
- It attracts the investors by showing a low debt equity ratio and maintaining the clean balance sheet.
- It is one of the ways of complying the current financing norms so as it does not penalize for non-compliance of current financing norms, which will affect the reputation and thereby future investors.
- The company use off balance sheet financing to preserve the borrowing capacity for example as the company is near to attaining the borrowing limit as describe in the articles so the company will not use direct financing so as to manage the risk and keep the investors’ faith.
- Since off balance sheet financing does not affect the balance sheet. hence the reputation and goodwill of the company or business organization is to be maintained and which will continue to attract the new investors as off-balance sheet financing require limited disclosure in notes to accounts.
Is Off-Balance Sheet Financing Legal?
It is the indirect way of financing the organization so as to maintain the debt equity ratio. It is legal due to the following justifications:
- Security Exchange Commission and Generally accepted accounting principles require the companies to disclose the sheet financing in notes to accounts.
- It is done in the form of investment in partnerships or leasing etc. which are reflected in the balance sheet as net figure of investment in the partnership firm and if any investor wants to analyze the balance sheet of partnership can write to the company and company will provide it as per the norms of the company. similarly, in the lease the terms of the lease are to be mentioned in the notes to accounts.
Hence off-balance sheet financing is legal unless it involves fraudulent activities or indirect financing does not show in financial statements.
Benefits of Off-Balance Sheet Financing
Some of the benefits are as under:
- Business does not need to disclose off-balance sheet financing in the financial statements directly as it is neither the asset nor the direct liability of the business organization.
- Business can be better managed and financed through the sheet financing in a legal and disciplined manner.
- Off balance sheet financing processes little risk to the company which is less than the direct financing risk.
- The additional finance can be raised through the sheet financing without affecting the debt burden and the current debt equity ratio.
- It allows the business in accomplishing its tasks and achieving the higher goals by expansion and diversification.
- With the sheet financing the relationship of the organization with investors, suppliers, creditors and other stakeholders does not affected nor the organization needs to take permission for the sheet financing from stakeholders.
Disadvantages of Off-Balance Sheet Financing
Some of the disadvantages are as under:
- It increases the risk of the organization as it is the hidden liability.
- It can affect the relationship with the investors as if there is a default in payment of off balance sheet financing and it is disclosed in the market the reputation of the organization will be affected and which will indirectly affect the investors.
- It is the borrowing beyond the limit which creates the doubt and continuity of the business or fraudulent activities.
- It can be used as a tool to hide the liabilities which affect the investors.
Conclusion
Off balance sheet financing is one of the indirect way of financing the business organization and it is done through investment in the partnerships, creating the shell companies, arranging the operating lease, etc. It is an advantage as well as disadvantage for the organization as through the sheet financing the organization can grow without affecting the debt pressure whereas financing or borrowing beyond the capacities may create the doubt on the organization. Organizations can use it as a tool to hide the liabilities but the accounting principles require some disclosure on the sheet financing which can be analyzed by the analysts.
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