Off balance sheet financing means providing funds to a subsidiary or project company where project’s related assets, liabilities and others are held and not considering it into the liability and assets sides of parent or sponsor company’s balance sheet.
In general, when a company need funds to expand its business by purchasing assets, hiring personnel or by acquiring other businesses, they might use debt financing as one of the main source to raise money.
After taking loan from banks or financial institutions, the company shows the debt taken on the liability side as either short-term or long-term liability and cash received from lender on the asset side of the balance sheet.
Whereas in case of Off balance sheet debt, the sponsor company commit or guarantee for something without actually recording the liability in its own balance sheet. In other words, it exists when a company set up a new organisation to borrow money without borrowing cash directly through its own assets and liabilities.
Example of Off Balance Sheet financing
Suppose Company A is planning to put a new metro project in city Y. For this, company A has to purchase lots of machinery and other assets. In such a case, company A may have following options;
- sign a joint venture agreement with other shareholders to establish a new legal entity and obtain fresh debt based on the estimated cash inflows of the project, or
- Obtain fresh financing into company A.
However, if company A already have debt and they don’t want to take additional risk of debt based on the project viability, then they might choose the first option instead of the the second one.
By creating a joint venture agreement or separate legal entity, company can take out the debt and project risk from its parent company’s account to the assets and liability side of new entity.Special purpose vehicle (SPV) or entity is one of the best example of creating off balance sheet financing exposure.
This type of financing helps the parent company:
- to reduce risk of the project.
- reduce the impact of the project on the cost of existing parent company.
- maintain debt-to-equity ratio by maintaining debt at or below a prescribed level.
- to maintain good credit rating.
However, keeping debt off balance sheet may not reduce liability of the project company. As a investor, while analyzing overall financial position, you should take all special purpose vehicle entity sponsored by the company and it’s subsidiaries financial statements into consideration.