WHAT IS OFF-BALANCE SHEET FINANCING?
Off-Balance Sheet financing is a method of financing used to raise finance without recording a liability. This helps in reducing the level of debt in the company. Normally, if Company A takes a loan from a bank, it records a loan on its liabilities and cash or bank on its assets. Off-Balance sheet financing is a method to not record the loan on the liabilities side. This may seem illegal but is actually a legitimate process very much allowed by the Generally Accepted Accounting Principles (GAAP). Off-Balance sheet financing lowers the debt equity ratio, presenting a lucrative financial statement to the investors. However, owing to minimal disclosure requirements, off-balance sheet financing may turn out to be deceitful. Since it understates the liabilities of a company, it can be to some extent considered as a violation of the accounting principle of full disclosure.
A company has two options- either purchase an asset or lease the asset. Purchasing the asset would entail arranging for funds to purchase the asset, in addition to the funds that will be blocked. Moreover, arranging for funds will create a liability on the balance sheet of the lessee either in the form of a bank loan, or debentures or increased equity or capital creditors if the asset is purchased on credit. On the other hand, leasing an asset would mean the lessee books the lease rentals as expenses while allowing the lessor to retain the leased asset in its balance sheet. This not only reduces the overall requirement of funds of the lessee but also cleans the balance sheet to reflect a reduced liability to the extent of cost of the asset. This influences ratios such as the debt equity ratio, reflecting a lower debt to equity.
Although it may be argued that a leveraged capital will create opportunities for trading on equity, but a highly leveraged capital will also increase the financial risk of the company, laying on it the obligations of interest payments. If the company is to incur losses, the interest obligations cannot be waived off. Therefore, managers strive to arrive at an optimal debt equity mix. Further, the company may require to maintain a certain level of debt equity ratio for other debt it has. These are called debt covenants. Therefore, a company may opt for off-balance sheet financing for various reasons, not all of which are detrimental to the interests of the stakeholders or potential shareholders.
THE CONCEPT AND PROCESS OF SECURITIZATION
The credit risk of 2008 and the subsequent market crash paved way for an innovative concept of reducing credit risk of businesses and led to the birth of securitization. This is because most of the problems in the economy stemmed from securitised mortgages. Securitization is the process of converting the illiquid assets of a company into liquid assets. The process is fairly simple, but the regulations, ambiguity in tax laws, an underdeveloped market makes it difficult to pragmatically implement it.
Suppose Bank A extends loans to various customers, with different maturity periods. These loans advanced form assets of the bank, i.e. the bank has assets, but illiquid assets which cannot be converted into cash immediately. This ties up funds available with the banks and creates credit risk. To eliminate this risk, a Special Purpose Vehicle (SPV) is incorporated, usually in the form of a trust or a company especially for the purpose of securitization. The SPV issues securitised instruments in the market, which are subscribed to by the investors. These instruments are heavily dependent on the performance of the underlying assets and therefore, investors want some form of security or assurance against these instruments, which may be provided in the form of a guarantee. The money received from the subscription is used to then purchase the assets of the bank at their present value. The bank transfers the legal rights of the assets to the SPV but retains the operational rights, meaning, it is the responsibility of the bank to collect the principal repayments and the interest payments. The repayments received by the bank is transferred to the SPV, which then refunds the investors.
HOW DOES SECURITIZATION FACILITATE OFF-BALANCE SHEET FINANCING?
Securitization, as explained, is therefore a process to convert the illiquid assets of a company to liquid assets, improving the liquidity of a business. But, how exactly does this happen?
When the assets, in the form of receivables, are sold off to an SPV, it removes the financial assets from the assets side of the balance sheet. On the other hand, cash or liquid assets increases due to the purchase consideration received from the SPV.
Consider this balance sheet, before securitization:
| LIABILITIES | AMOUNT | ASSETS | AMOUNT |
| Total Liabilities | 10,000,000 | Financial Assets | 55,000,000 |
| Liquid Assets | 45,000,000 | ||
| 10,000,000 | 10,000,000 |
This balance sheet shows the assets side having two components:
- Financial Assets
- Liquid Assets
This is the position of the company before it has sold out the financial assets represented by loans and advances to an SPV. The position of the balance sheet changes as follows, once these financial assets are sold out
| LIABILITIES | AMOUNT | ASSETS | AMOUNT |
| Total Liabilities | 10,000,000 | Financial Assets | 0 |
| Liquid Assets | 10,000,000 | ||
| 10,000,000 | 10,000,000 |
Once the assets have been sold out to an SPV, the SPV makes an immediate payment to the company thus converting the liquidity position of the company. A comparison of the liquidity ratios of the balance sheets reveals that the liquidity position of the company in the second scenario, i.e. after securitization is better than the first. The company can use it to its advantage to secure short-term loans such as term loans or raise money from the money market.
