What Is Off Balance Sheet Financing?

When small businesses need funds to expand, purchase assets or hire personnel, they may use debt financing if they are sufficiently creditworthy. These debt financing transactions appear on the cash flow statement and on the balance sheet. Occasionally, businesses will use debt financing to finance projects, subsidiaries and other assets in which they own a minority stake. When this occurs, the debt used may not show up on the cash flow statement and balance sheet.

Understanding Off-Balance-Sheet Basics

The definition of off-balance-sheet is nearly literal. According to Accounting Tools, "off-balance-sheet" means it does not appear on the balance sheet of a company's financial statements. Off-balance sheet financing is a legitimate, legal and permissible accounting method recognized by Generally Accepted Accounting Principles, or GAAP, as long as GAAP classification methods are followed. This form of financing is nearly always debt financing, so the debt does not appear as a liability on the balance sheet.

Off-Balance-Sheet Goals

Investopedia reports that the goal of off-balance sheet financing is to reduce or maintain a company's debt at or below a prescribed level so that its debt-to-equity ratio is low. When a company has a favorable ratio, that company appears to be a good credit risk, which is good news for businesses who need financing or investors to grow. In addition, a company may have other debt, including bank loans or bonds, that requires the company to maintain a minimum debt-to-equity ratio. Those requirements are called debt covenants. A large purchase using debt financing could cause the company to be noncompliant with those debt covenants and consequently trigger a default.

Off-Balance-Sheet Examples

When companies own a minority stake in another company, that stake may be eligible for treatment as an off-balance sheet item and any debt financing associated with that asset will typically be treated the same way. Hence, joint ventures, strategic or R&D partnerships and large projects are often financed off-balance-sheet. Enron collapsed under the weight of off-balance-sheet financing, appropriate and inappropriate, it had engaged in for myriad utility and pipeline projects, joint ventures and strategic partnerships.

Operating Lease Example

Operating leases are a more common example of off-balance-sheet financing. With an operating lease, the lessor keeps the asset on its balance sheet and the company leasing the asset only reports the rental expense. Its opposite, a capital lease, would show up as a liability on the lessee's balance sheet, and the leased asset as an asset on the lessee's balance sheet.