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There are two different categories of commercial financing from an accounting perspective: on-balance-sheet financing and off-balance-sheet financing. Understanding the difference can be critical to obtaining the right type of commercial financing for your company.
Put simply, on-balance-sheet financing is commercial financing in which capital expenditures appear as a liability on a company’s balance sheet. Commercial loans are the most common example: Typically, a company will leverage an asset (such as accounts receivable) in order to borrow money from a bank, thus creating a liability (i.e., the outstanding loan) that must be reported as such on the balance sheet.
With off-balance-sheet financing, however, liabilities do not have to be reported because no debt or equity is created. The most common form of off-balance-sheet financing is an operating lease, in which the company makes a small down payment upfront and then monthly lease payments. When the lease term is up, the company can usually buy the asset for a minimal amount (often just one dollar).
The key difference is that with an operating lease, the asset stays on the lessor’s balance sheet. The lessee only reports the expense associated with the use of the asset (i.e., the rental payments), not the cost of the asset itself.
Why Does It Matter?
This might sound like technical accounting-speak that only a CPA could appreciate. In the continuing tight credit environment, however, off-balance-sheet financing can offer significant benefits to any size company, from large multi-nationals to mom-and-pops.
These benefits arise from the fact that off-balance-sheet financing creates liquidity for a business while avoiding leverage, thus improving the overall financial picture of the company. This can help companies keep their debt-to-equity ratio low: If a company is already leveraged, additional debt might trip a covenant to an existing loan.
The trade-off is that off-balance-sheet financing is usually more expensive than traditional on-balance-sheet loans. Business owners should work closely with their CPAs to determine whether the benefits of off-balance-sheet financing outweigh the costs in their specific situation.
Other Types of Off-Balance-Sheet Financing
An increasingly popular type of off-balance-sheet financing today is what’s known as a sale/leaseback. Here, a business sells property it owns and then immediately leases it back from the new owner. It can be used with virtually any type of fixed asset, including commercial real estate, equipment and commercial vehicles and aircraft, to name a few.
A sale/leaseback can increase a company’s financial flexibility and may provide a large lump sum of cash by freeing up the equity in the asset. This cash can then be poured back into the business to support growth, pay down debt, acquire another business, or meet working capital needs.
Factoring is another type of off-balance-sheet financing. Here, a business sells its outstanding accounts receivable to a commercial finance company, or “factor.” Typically, the factor will advance the business between 70 and 90 percent of the value of the receivable at the time of purchase; the balance, less the factoring fee, is released when the invoice is collected.
Like with an operating lease, no debt is created with factoring, thus enabling companies to create liquidity while avoiding additional leverage. The same kinds of off-balance-sheet benefits occur in both factoring arrangements and operating leases.
Keep in mind that strict accounting rules must be followed when it comes to properly distinguishing between on-balance-sheet and off-balance-sheet financing, so you should work closely with your CPA in this regard. But with the continued uncertainty surrounding the economy and credit markets, it’s worth looking into the potential benefits of off-balance-sheet financing for your company.