Definition of 'Off-Balance-Sheet Financing'

A form of financing in which large capital expenditures are kept off of a company's balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep their debt to equity (D/E) and leverage ratios low, especially if the

inclusion of a large expenditure would break negative debt covenants.

Investopedia explains 'Off-Balance-Sheet Financing'

Contrast to loans, debt and equity, which do appear on the balance sheet. Examples of offbalance-sheet financing include joint ventures, research and development partnerships, and operating leases (rather than purchases of capital equipment). Operating leases are one of the most common forms of off-balance-sheet financing. In these cases, the asset itself is kept on the lessor's balance sheet, and the lessee reports only the required rental expense for use of the asset. Generally Accepted Accounting Principles in the U.S. have set numerous rules for companies to follow in determining whether a lease should be capitalized (included on the balance sheet) or expensed. This term came into popular use during the Enron bankruptcy. Many of the energy traders' problems stemmed from setting up inappropriate off-balance-sheet entities.

Off-Balance-Sheet Entities: An Introduction

January 14 2011| Filed Under Stocks Off-balance-sheet entitles are complex transactions where theory and reality collide. To understand how off-balance-sheet entities work, it is useful to have an understanding of corporate balance sheets. A balance sheet, also known as a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth). (For a more detailed overview of balance sheets, see Reading The Balance Sheet and Breaking Down The Balance Sheet.) TUTORIAL: Financial Concepts Investors use balance sheets to evaluate a company's financial health. In theory, the balance sheet provides an honest look at a firm's assets and liabilities, enabling investors to make a determination regarding the firm's health and compare the results against the firm's competitors. Because assets are better than liabilities, firms want to have more assets and fewer liabilities on their balance sheets. Off-Balance-Sheet Entities: The Theory

Off-balance-sheet entities are assets or debts that do not appear on a company's balance sheet. For example, oil-drilling companies often establish off-balance-sheet subsidiaries as a way to finance oil exploration projects. In a clean and clear example, a parent company can set up a subsidiary company and spin it off by selling a controlling interest (or the entire company) to investors. Such a sale generates profits for the parent company from the sale, transfers the risk of the new business failing to the investors and lets the parent company remove the subsidiary from its balance sheet. Off-Balance-Sheet Entities: The Reality Too often, however, offbalance-sheet entities are used to artificially inflate profits and make firms look more financially secure than they actually are. A complex and confusing array of investment vehicles, including but not limited to collateralized debt obligations, subprime-mortgage securities and credit default swaps are used to remove debts from corporate balance sheets. The parent company lists proceeds from the sale of these items as assets but does not list the financial obligations that come with them as liabilities. For example, consider loans made by a bank. When issued, the loans are typically kept on the bank's books as an asset. If those loans are securitized and sold off as investments, however, the securitized debt (for which the bank is liable) is not kept on the bank's books. This accounting maneuver helps the issuing firm's stock price and artificially inflates profits, enabling CEOs to claim credit for a solid balance sheet and reap huge bonuses as a result. (Sneaky Subsidiary Tricks Can Cloud Financials provides insight into how the process works with subsidiaries, and it's not the only trick companies use.) A History of Fraud The Enron scandal was one of the first developments to bring the use of off-balance-sheet entities to the public's attention. In Enron's case, the company would build an asset such as a power plant and immediately claim the projected profit on its books even though it hadn't made one dime from it. If the revenue from the power plant was less than the projected amount, instead of taking the loss, the company would then transfer these assets to an offthe-books corporation, where the loss would go unreported. (For more insight into this scandal, read Enron's Collapse: The Fall Of A Wall Street Darling .) Basically the entire banking industry has participated in the same practice, often through the use of credit default swaps (CDS). The practice was so common that just 10 years after JPMorgan's 1997 introduction of the CDS, it grew to an estimated $45 trillion business, according to the International Swaps and Derivatives Association. That's more than twice

the size of the U.S. stock market, and only the beginning as the CDS market would later be reported in excess of $60 trillion. (Credit Default Swaps: An Introduction, provides a closer look at these products.)
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The use of leverage further complicates the subject of off-balance-sheet entities. Consider a bank that has $1,000 to invest. This amount could be invested in 10 shares of a stock that sells for $100 per share. Or the bank could invest the $1,000 in five options contracts that would give it control over 500 shares instead of just 10. This practice would work out quite favorably if the stock price rises, and quite disastrously if the price falls. Now, apply this situation to banks during the credit crisis and their use of CDS instruments, keeping in mind that some firms had leverage ratios of 30 to one. When their bets went bad, American taxpayers had to step in to bail the firms out in order to keep them from failing. The financial gurus who orchestrated the failures kept their profits and left the taxpayers holding the bill. The Future of Off-Balance-Sheet Entities Efforts to change accounting rules and pass legislation to limit the use of off-balance-sheet entities do nothing to change the fact that companies still want to have more assets and fewer liabilities on their balance sheets. With this in mind, they continue to find ways around the rules. Legislation may reduce the number of entities that don't appear on balance sheets but loopholes will continue to remain firmly in place. (To learn more, see What Caused The Credit Crisis.)

How To Evaluate A Company's Balance Sheet

June 03 2011| Filed Under Investing Basics For stock investors, the balance sheet is an important consideration for investing in a company because it is a reflection of what the company owns and owes. The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance and capitalization structure. Tutorial: Financial Statement AnalysisIn this article, we'll look at four evaluative perspectives on a company's asset performance: (1) the cash conversion cycle, (2) the fixed asset turnover ratio, (3) the return on assets ratio and (4) the impact of intangible assets.

The Cash Conversion Cycle (CCC) The cash conversion cycle is a key indicator of the adequacy of a company's working capital position. In addition, the CCC is equally important as the measurement of a company's ability to efficiently manage two of its most important assets - accounts receivable and inventory. Calculated in days, the CCC reflects the time required to collect on sales and the time it takes to turn over inventory. The shorter this cycle is, the better. Cash is king, and smart managers know that fast-moving working capital is more profitable than tying up unproductive working capital in assets. CCC = DIO + DSO DPO DIO - Days Inventory Outstanding DSO - Days Sales Outstanding DPO - Days Payable Outstanding

There is no single optimal metric for the CCC, which is also referred to as a company's operating cycle. As a rule, a company's cash conversion cycle will be influenced heavily by the type of product or service it provides and industry characteristics. Investors looking for investment quality in this area of a company's balance sheet need to track the CCC over an extended period of time (for example, five to 10 years), and compare its performance to that of competitors. Consistency and/or decreases in the operating cycle are positive signals. Conversely, erratic collection times and/or an increase in inventory on hand are generally not positive investment-quality indicators. (To read more on CCC, see Understanding the Cash Conversion Cycle and Using The Cash Conversion Cycle.) The Fixed Asset Turnover Ratio Property, plant and equipment (PP&E), or fixed assets, is another of the "big" numbers in a company's balance sheet. In fact, it often represents the single largest component of a company's total assets. Readers should note that the term fixed assets is the financial professional's shorthand for PP&E, although investment literature sometimes refers to a company's total non-current assets as its fixed assets. A company's investment in fixed assets is dependent, to a large degree, on its line of

business. Some businesses are more capital intensive than others. Natural resource and large capital equipment producers require a large amount of fixed-asset investment. Service companies and computer software producers need a relatively small amount of fixed assets. Mainstream manufacturers generally have around 30-40% of their assets in PP&E. Accordingly, fixed asset turnover ratios will vary among different industries. The fixed asset turnover ratio is calculated as:

Average fixed assets can be calculated by dividing the year-end PP&E of two fiscal periods (ex. 2004 and 2005 PP&E divided by two).
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This fixed asset turnover ratio indicator, looked at over time and compared to that of competitors, gives the investor an idea of how effectively a company's management is using this large and important asset. It is a rough measure of the productivity of a company's fixed assets with respect to generating sales. The higher the number of times PP&E turns over, the better. Obviously, investors should look for consistency or increasing fixed asset turnover rates as positive balance sheet investment qualities. The Return on Assets Ratio Return on assets (ROA) is considered to be a profitability ratio - it shows how much a company is earning on its total assets. Nevertheless, it is worthwhile to view the ROA ratio as an indicator of asset performance. The ROA ratio (percentage) is calculated as:

Average total assets can be calculated by dividing the year-end total assets of two fiscal periods (ex 2004 and 2005 PP&E divided by 2). The ROA ratio is expressed as a percentage return by comparing net income, the bottom line of the statement of income, to average total assets. A high percentage return implies

well-managed assets. Here again, the ROA ratio is best employed as a comparative analysis of a company's own historical performance and with companies in a similar line of business. The Impact of Intangible Assets Numerous non-physical assets are considered intangible assets, which can essentially be categorized into three different types: intellectual property goodwill (the cost of an investment in excess of book value). Unfortunately, there is little uniformity in balance sheet presentations for intangible assets or the terminology used in the account captions. Often, intangibles are buried in other assets and only disclosed in a note to the financials. The dollars involved in intellectual property and deferred charges are generally not material and, in most cases, don't warrant much analytical scrutiny. However, investors are encouraged to take a careful look at the amount of purchased goodwill in a company's balance sheet because some investment professionals are uncomfortable with a large amount of purchased goodwill. Today's acquired "beauty" sometimes turns into tomorrow's "beast". Only time will tell if the acquisition price paid by the acquiring company was really fair value. The return to the acquiring company will be realized only if, in the future, it is able to turn the acquisition into positive earnings. Conservative analysts will deduct the amount of purchased goodwill from shareholders equity to arrive at a company's tangible net worth. In the absence of any precise analytical measurement to make a judgment on the impact of this deduction, try using plain common sense. If the deduction of purchased goodwill has a material negative impact on a company's equity position, it should be a matter of concern to investors. For example, a moderately leveraged balance sheet might look really ugly if its debt liabilities are seriously in excess of its tangible equity position. Companies acquire other companies, so purchased goodwill is a fact of life in financial accounting. Investors, however, need to look carefully at a relatively large amount of purchased goodwill in a balance sheet. The impact of this account on the investment quality of a balance sheet needs to be judged in terms of its comparative size to shareholders' equity and the company's success rate with acquisitions. This truly is a judgment call, but one that needs to be considered thoughtfully. (patents, copyrights, trademarks, brand names, etc.), deferred charges (capitalized expenses) and purchased

Conclusion Assets represent items of value that a company owns, has in its possession or is due. Of the various types of items a company owns; receivables, inventory, PP&E and intangibles are generally the four largest accounts in the asset side of a balance sheet. As a consequence, a strong balance sheet is built on the efficient management of these major asset types and a strong portfolio is built on knowing how to read and analyze financials statements.

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