Have you noticed that the larger and more successful your business gets, the more complicated it gets too?
You have to start worrying about new tax and legal matters, change the way you keep track of finances, how you hire, change your marketing strategy, and so much more. The list goes on and on.
Today we’re exploring “off balance sheet financing,” or OBS financing for short and how it can be utilized in your business as it grows in size. For anyone that’s never delved into off balance sheet financing or heard of it before, it can seem a little daunting at first.
What Is Off Balance Sheet Financing?
Off balance sheet financing is essentially where a company does not include liability on its balance sheet. Let’s break down a few terms quickly to better understand how it all comes together.
● Balance sheet - document to list the company’s assets (liabilities + equity).
● Assets - resources with economic value of the company, such as funds, equity, equipment etc.
● Liabilities - the financial debt or obligations of the company. These can include loans, accounts payable, deferred revenues, accrued expenses, mortgages, etc.
● Equity - percentage of “ownership” in the company, typically taken by investors during funding periods.
● Special purpose vehicle (SPV) - carries assets or liabilities instead of the parent company. A legal status that makes its obligations secure even if the parent company goes bankrupt.
A company’s assets are all of the liabilities and equities of shareholders of a given company.
The balance sheet keeps track of all of that information to be recalled and reviewed at will. This helps to keep the company accountable and allows anyone to see what the financial status of the company is at a given point.
At the core of off balance sheet financing, a company receives funding without it affecting its balance sheet. In other words, off balance sheet financing allows a company to get funds without it impacting the reported assets of that company.
Examples of Off Balance Sheet Financing
When you ask around and talk to businesses and financiers about off balance sheet financing, you’ll find that there are a couple of different forms of OBS financing to take into consideration.
One of the more traditional and older forms of off balance sheet financing is through an “operating lease,” where the company uses a contract to lease an asset from a lessor, rather than reporting that asset and liability on their balance sheet.
One of the benefits of operating leases is the potential tax benefits. An operating lease may allow you to deduct your payments as operating expenses during the period in which you pay them. Lowering your taxable income and net cost for the equipment.
In order to qualify for a true operating lease, a lease contract must satisfy the following criteria. The life of the lease must be 75% or greater of the asset's useful life. The present value of lease payments is less than 90 percent of the equipment's fair market value. The lease cannot contain a bargain purchase option (i.e., purchase option for less than the fair market value).
Selling Accounts Receivables
Another form of off balance sheet financing is where a business will “sell” its accounts receivables, which results in removing an asset (and debt) from the balance sheet. This is useful if a business feels that the accounts receivables are an “uncertain” asset and doesn’t want to affiliate with it any longer.
Some companies can finance purchases of inventory through certain kinds of debt, where the principal repayments or interest are a function of the price of the commodity itself.
Take-or- Pay Contract
An agreement between a seller and buyer, where the buyer pays some amount even if no product or service is provided, commonly used in the industries for metal, paper, chemical, and natural-gas. This is used by companies to ensure that certain products will be produced regardless, and the company in return guarantees to at least pay a certain minimum so that the seller does not go empty handed.
This is nearly identical to the take-or- pay contract, where some natural-gas companies will use similar processes to ensure that there is distribution or processing within their market.
Benefits of Financing Off the Balance Sheet
Off balance sheet financing is known to reduce risk exposure for the company, making it a popular financial tactic for some businesses. It does this by taking the unwanted, negative aspects of the company’s assets/liabilities (e.g., debt) and transferring it to the SPV.
The general idea for off balance sheet financing is that anyone else looking into the company and their balance sheet won’t see those formerly negative liabilities, such as debt, because it is no longer a part of the “parent company” and is now a part of the SPV company. Your debt to equity ratio could improve.
This also gives the SPV company an opportunity to raise additional capital for the parent company because it doesn’t have the majority of debt-associated balance sheet details that the parent company has. In other words, the SPV may have a higher credit rating and can get better rates, thus reducing costs of raising capital.
Some businesses may have contractual financial agreements with suppliers, vendors, partners, and other affiliations that can cause them to be limited in the amount of funding they receive, due to caps on outstanding debt.
But with off balance sheet financing, a company can still receive funding through more creative and involved means without actually taking on any debt - or transferring certain debt off the parent company through an SPV.
Off balance sheet financing can also make the parent company look financially “healthier” to investors and creditors, because certain assets are being transferred elsewhere, including debts that would otherwise appear to lower the financial credibility of the company.
If you are considering utilizing off balance sheet financing in your company, ensure that you consult with a financial professional to over your examples of off balance sheet financing and get opinions from different financiers to assess the level of risk and whether or not it’s a smart move for your particular business situation.
Off balance sheet financing can be a great way to reduce debt and indirectly lower the bottom line, which means more cash in your company’s pockets. Contact Trust Capital today to learn more about off balance sheet financing and whether or not it’s the best choice for your business when seeking funding. We can discuss your credit risk and give you a no obligation approval for off balance sheet financing.