Download Off-Balance Sheet Financing Off-balance sheet

Off-Balance Sheet
Financing
Dr Clive Vlieland-Boddy
Why is Off-Balance Sheet
Financing Important?
• In other words, why are firms so interested in
“hiding” debt?
– If analysis reveals that debt is excessive,
companies may face the prospect of a
reductions in bond ratings, resulting in
higher cost of debt.
– Likewise, excessive leverage can result in
a higher cost of equity capital and a
consequent reduction in stock price.
“Window Dressing” Financial
Statements: Examples #1
• A company is concerned that its liquidity may not be
perceived as sufficient.
• Prior to the end of its financial reporting period it
takes out a short-term loan from its bank in order to
increase its reported cash balance. The same result
can also be obtained by delaying payment of
accounts payable.
• In both cases, the company’s cash and current
assets have been increased.
• Even though current liabilities are also higher, the
liquidity of the balance sheet has been improved
and the company appears somewhat stronger from
a liquidity point of view.
“Window Dressing” Financial
Statements: Examples # 2
• A company’s level of accounts receivable are
perceived to be too high, thus indicating possible
collection problems and a reduction in liquidity.
• Prior to the statement date, the company offers
customers an additional discount in order to induce
them to pay the accounts more quickly.
• Although the profitability on the sale has been
reduced by the discount, the company reduces its
accounts receivable, increases its reported cash
balance and presents a somewhat healthier financial
picture to the financial markets.
“Window Dressing” Financial
Statements: Examples # 3
• A company may face the maturity of a long-term
liability, such as the scheduled maturity of a bond.
• The amounts coming due will be reported as a
current liability (current maturities of long-term
debt), thus reducing the net working capital of the
company.
• Prior to the end of its accounting period, the
company renegotiates the debt to extend the
maturity date of the payment or refinances the
indebtedness with longer-term debt.
• The indebtedness is, thus, reported as a long-term
liability and net working capital has been increased.
“Window Dressing” Financial
Statements: Examples # 4
• The company’s financial leverage is deemed
excessive, resulting in lower bond ratings and
a consequent increase in borrowing costs.
• To remedy the problem, the company issues
new common equity and utilizes the proceeds
to reduce the indebtedness.
• The increased equity provides a base to
support the issuance of new debt to finance
continued growth.
Motives for using Off-Balance
Sheet Financing
• In general, companies desire to present a
balance sheet with sufficient liquidity and less
indebtedness.
• The reasons for this are as follows: liquidity and
the level of indebtedness are viewed as two
measures of solvency.
• Companies that are more liquid and less highly
financially leveraged are generally viewed as
less likely to go bankrupt.
• As a result, the risk of default on their bonds is
less, resulting in a higher rating on the bonds
and a lower interest rate.
Off-Balance Sheet Financing
• Off-balance sheet financing means that
either liabilities are kept off of the face of
the balance sheet.
• In this module, we discuss leases,
pensions, variable interest entities (called
Special Purpose Vehicles SPVs or Special
Purpose Entities. SPE’s in the past), and
derivatives.
Leasing
•
•
A lease is a contact between the owner of an
asset (the lessor) and the party desiring to use
that asset (the lessee).
Generally, leases provide for the following
terms:
1. The lessor allows the lessee the unrestricted right to
use the asset during the lease term
2. The lessee agrees to make periodic payments to the
lessor and to maintain the asset
3. Title to the asset remains with the lessor, who
usually retakes possession of the asset at the
conclusion of the lease.
Advantages to Leasing
 Leases often require much less equity
investment than bank financing. That is, banks
may only lend a portion of the asset’s cost and
require the borrower to make up the difference
form its available cash. Leases, on the other
hand, usually only require that the first lease
payment be made at the inception of the lease.
 Since leases are contracts between two willing
parties, their terms can be structured in any
way to meet their respective needs.
 If properly structured, neither the leased asset
not the lease liability are reported on the face
of the balance sheet.
Financing or Capital vs.
Operating Leases
Financing / Capital lease method.
• Essentially a way to finance the asset
• This method requires that both the lease asset and
the lease liability be reported on the balance sheet.
The leased asset is depreciated like any other longterm asset. The lease liability is amortized like a
note, where lease payments are separated into
interest expense and principal repayment.
• Example: A new Truck or Plane
Operating Lease
Operating lease method.
• Under this method, neither the lease
asset nor the lease liability is on the
balance sheet. Lease payments are
recorded as rent expense when paid.
• Example: Renting a car for 3 days
from Hertz!
Accounts Receivable Factoring
• One of the major assets of many businesses
are the RA, the monies due from customers.
• These can form the source of finance.
• Either Recourse where the responsibility of
collection is with the company or Non
Recourse where the financing entity take on
this responsibility.
• Again “Substance over Legal Form” will
apply
Advantages of Factoring
• A short term quick solution that can bring
cash and help the company meet its short
term obligations.
• The fees are usually based on the credit
worthiness of the company’s accounts
receivable (the company’s clients) and not on
the credit worthiness of the company itself.
• The transaction is not secured with any of the
company’s assets.
• The company does not increase its debt
putting at risk any bank covenants.
Disadvantages of Factoring
• Is it only a short term solution that should be
used when the company faces liquidity
problems.
• The fees including any interest payment can
be substantial.
• It can be perceived by creditors and
investors as a signal of debt and liquidity
problems.
• Often seen as first step towards bankruptcy!
•
Recourse Factoring
• Here basically a loan or advance is
provided to the company by the finance
entity.
• The assets remain the property of the
company.
• The AR are shown in current assets and
the loan as a current liability
Non Recourse Factoring
• Here the debt is sold and the collection
down to the financing entity.
• The difference between what the dedt is
sold for and what is received is recognised
in the income statement.
• Normally not 100% financed so balance
unfinanced will still show under current
assets.
Pensions
• After many bankruptcies where the
employees retirement funds have been
lost, the concept of taking the pension
responsibility out of the company has
gained considerable momentum.
• Now only a few companies still hold the
pension within their own control.
Pensions
Companies frequently offer retirement plans as an
additional benefit for their employees. There are
generally two types of plans:
Defined contribution plan.
This plan has the company make periodic
contributions to an employee’s account (usually
with a third party trustee like a bank), and many
plans require an employee matching
contribution.
Pensions
Defined benefit plan.
• This plan has the company make periodic
payments to an employee after retirement.
Payments are usually based on years of service
and/or the employee’s salary. The company may
or may not set aside sufficient funds to make
these payments. As a result, defined benefit
plans can be overfunded or underfunded.
Special Purpose Vehicles SPV’s or
Special Purpose Entities (SPE’s)
• Created to hold assets and or debt away
from the sponsor company.
• Takes risks away from the sponsor
company.
• To avoid consolidation must be under
separate ownership and control from
sponsor.
Project and Real Estate Financing
•
•
•
•
SPv’s are often used to take uncertainty away from
the sponsors balance sheet.
Real Estate transactions are usually heavily funded
and can normally be separately funded by loans.
Taking the asset and the debt away from the
sponsors balance sheet can greatly improve the
liquidity appearance.
Likewise speculative activities such as say the
development of a software project or developing a
new product could be taken off the balance sheet to
a separately controlled SPV. If it fails then it would
have no negative effect on the sponsors Income
Statement.
Reporting of Consolidated SPV’s
• Accounting Standards require consolidation.
• Generally, any entity that lacks
independence from the sponsoring company
and lacks sufficient capital to conduct its
operations apart from the sponsoring
company, must be consolidated with
whatever entity bears the greatest risk of loss
and stands to reap the greatest rewards from
its activities.
Enron
• They used SPV with disguised ownership
through New York Attorneys.
• They created false profits selling off assets
for many times their real value.
• To enable these to be done, they would
back the SPV’s borrowings by loaning
shares in Enron as security.
Lehmann Brothers
• They employed a system called Repro.
• A day or so before the year end they would
sell off a large portfolio of Sub Prime Loans
to another bank at full book value.
• The balance sheet then showed a false but
strong position.
• A few days later they would buy the loans
back… As agreed!