Off-balance sheet financing refers to an arrangement in which a business obtains funds or equipment from external sources, but does not report the transaction as an asset or a liability on its balance sheet. However, the business may mention the transaction in the notes to its accounts. For example, instead of buying new equipment, the business may choose to lease it so it does not become an asset or a liability. Off-balance sheet financing has several advantages.
A business usually doesn't have to include an item on the balance sheet because the item is neither an asset nor a liability. With a liability, the business eventually has to pay out money to an external party; for example, the bank that lends loan funds. Because the off-balance sheet item is not a liability, it poses little risk to the company. A business may turn an item into a non-liability by taking out a renewable lease instead of a loan it has to pay off, or by transferring the risk to a separate legal entity.
When a business takes on a new loan, it increases its debt burden. With off-balance sheet financing, the business obtains the funds or items it needs without affecting its debt burden. Because a business usually has a maximum amount of funds it can borrow, off-balance sheet financing gives the business the ability to use its remaining allowable borrowing capacity for other purposes. In this way, off-balance sheet financing allows the business to accomplish more tasks.
When a business signs a contract with a supplier or lender, the contract may require that the business limit its debt to a certain level. If the business needs funds or equipment and decides to take on a new loan, it may exceed the contractual limit. In the case of large corporations, the business may also have to obtain the approval of the directors to get new debts. Because off-balance sheet financing does not involve the business taking on debt, it does not affect a business' relationship with suppliers, lenders or directors.
Off-balance sheet financing does not affect the business' reported numbers and ratios. For example, the business will have the same levels of return on assets and debt ratio. In contrast, a loan often affects a business' reported numbers and ratios negatively, making it look less attractive to analysts, investors and creditors. Off-balance sheet financing makes the business appear financially healthier than if it were to obtain debt.