Question

Zoom Company currently has $500 million of assets $160 million of debt, and Net income last year was $12 million. Calculate the company's return on assets ratio and debt/equity ratio under the following assumptions or changes:

1. No changes in above.

2. Assuming the company had leased $30 million of its assets "off the balance sheet."

3. Assuming the company had leased $60 million of its assets "off the balance sheet."

4. Assuming the company had leased $90 million of its assets "off the balance sheet."

Based on a review of your calculations for the financial ratios above, explain why a firm might want to engage in "off balance sheet" financing.

Answer 1

Return on assets (ROA)	=Net income divided by total assets
	= $ 12 million / $ 500million
	0.024	or 3:125
Debt equity ratio	= Debt/Equity
	160/340
	0.47	or 4.7E+15:1.0E+16
Equity = Toal asset - debt	$ 500million - 160 million
	$ 340 million

KEY TAKEAWAYS

• Off-balance sheet (OBS) items are an accounting practice whereby a company does not include a liability on its balance sheet.
• While not recorded on the balance sheet itself, these items are nevertheless assets and liabilities of the company.
• Off-balance sheet items can be used to keep debt-to-equity (D/E) and leverage ratios low, facilitating cheaper borrowing and preventing bond covenants from being breached.
• The practice of off-balance sheet financing has come under increasing scrutiny after a number of accounting scandals revealed the mis-use of the practice.

Types of Off-Balance Sheet Items

There are several ways to structure off-balance sheet items. The following is a short list of some of the most common:

Operating Lease

An OBS operating lease is one in which the lessor retains the leased asset on its balance sheet. The company leasing the asset only accounts for the monthly rental payments and other fees associated with the rental rather than listing the asset and corresponding liability on its own balance sheet.At the end of the lease term, the lessee generally has the opportunity to purchase the asset at a drastically reduced price.

Leaseback Agreements

Under a leaseback agreement, a company can sell an asset, such as a piece of property, to another entity. They may then lease that same property back from the new owner.

Like an operating lease, the company only lists the rental expenses on its balance sheet, while the asset itself is listed on the balance sheet of the owning business.

Accounts Receivables

Accounts receivable (AR) represents a considerable liability for many companies. This asset category is reserved for funds that have not yet been received from customers, so the possibility of default is high. Instead of listing this risk-laden asset on its own balance sheet, companies can essentially sell this asset to another company, called a factor, which then acquires the risk associated with the asset. The factor pays the company a percentage of the total value of all AR upfront and takes care of collection. Once customers have paid up, the factor pays the company the balance due minus a fee for services rendered. In this way, a business can collect what is owed while outsourcing the risk of default.

How Off-Balance Sheet Financing Works

An operating lease, used in off-balance sheet financing (OBSF), is a good example of a common off-balance sheet item. Assume that a company has an established line of credit with a bank whose financial covenant condition stipulates that the company must maintain its debt-to-assets ratio below a specified level. Taking on additional debt to finance the purchase of new computer hardware would violate the line of credit covenant by raising the debt-to-assets ratio above the maximum specified level.

OBS financing is attractive to all companies, but particularly to those that are already highly levered. For a company that has a high debt-to-equity, increasing its debt may be problematic for several reasons.

First, for companies that already have high debt levels, borrowing more money is typically more expensive than for companies that have little debt because the interest charged by the lender is higher. Second, borrowing may increase a company’s leverage ratios causing agreements (called covenants) between the borrower and lender to be violated.

Third, partnerships, such as in those for R&D, are attractive to companies because R&D is expensive and may have a long time horizon before completion. The accounting benefits of partnerships are many. For example, accounting for an R&D partnership allows the company to add minimal liability to its balance sheet while conducting the research. This is beneficial because, during the research process, there is no high-value asset to help offset the large liability. This is particularly true in the pharmaceutical industry where R&D for new drugs takes many years to complete.

Lastly, OBS financing can often create liquidity for a company. For example, if a company uses an operating lease, capital is not tied up in buying the equipment since only the rental expense is paid out.