definition off balance sheet

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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 off-

balance-sheet financing include joint ventures, research and development partnerships, andoperating leases (rather than purchases of capital equipment).

Operating leases are one of the most common forms of off-balance-sheet financing. Inthese 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 AccountingPrinciples 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 IntroductionJanuary 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. Abalance sheet, also known as a "statement of financial

position", reveals a company'sassets,liabilitiesand owners' equity (net worth). (For a more

detailed overview of balance sheets, seeReading The Balance SheetandBreaking 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
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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 andspin it offbyselling 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 Financialsprovides 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 off-

the-books corporation, where the loss would go unreported. (For more insight into this

scandal, readEnron'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
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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.)

5-Star Stock Pick: CTLE

The use ofleverage 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 SheetJune 03 2011| Filed Under Investing Basics

For stock investors, thebalance sheetis an important consideration for investing in a

company because it is a reflection of what the company owns and owes. The strength of acompany's balance sheet can be evaluated by three broad categories of investment-quality

measurements:working capitaladequacy, 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) thecash conversion cycle, (2) the fixed

asset turnover ratio, (3) thereturn on assetsratio and (4) the impact ofintangible assets.
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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 CycleandUsing The Cash Conversion Cycle.)

The Fixed Asset Turnover Ratio

Property, plant and equipment(PP&E), orfixed 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
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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).

5-Star Stock Pick: CTLE

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 shouldlook 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 isearning 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 comparingnet income, the bottom

line of the statement of income, to average total assets. A high percentage return implies
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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: intellectualproperty (patents, copyrights,

trademarks, brand names, etc.),deferred charges(capitalized expenses) and purchased

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'stangible 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 successrate with acquisitions. This truly is a judgment call, but

one that needs to be considered thoughtfully.
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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 aregenerally the four largest accounts in the asset side of a balance sheet. As a consequence, a

strong balance sheet is built on theefficient management of these major asset types and a

strong portfolio is built on knowing how to read and analyze financials statements.

Read more:

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definition off balance sheet

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