Is the company whose stock you own carrying more debt than the balance sheet is showing? Most of the information about debt can be found on the balance sheet--but many debt obligations are not disclosed there. Here is a review of some off-balance-sheet transactions and what they mean for investors.
The term "off-balance-sheet" debt has recently come under the spotlight. The reason, of course, is Enron, which used underhanded techniques to shift debt off its balance sheet, making the company's fundamentals look far stronger than they were. That said, not all off–balance-sheet finance is shady. In fact, it can be a useful tool that all sorts of companies can use for a variety of legitimate purposes--such as tapping into extra sources of financing and reducing liability risk that could hurt earnings.
As an investor, it's your job to understand the differences between various off-balance-sheet transactions. Has the company really reduced its risk by shifting the burden of debt to another company, or has it simply come up with a devious way of eliminating a liability from its balance sheet?
A lot of investors don't know that there are two kinds of leases: capital leases, which show up on the balance sheet, and operating leases, which do not.
Under accounting rules, a capital lease is treated like a purchase. Let's say an airline company buying an airplane sets up a long-term payment lease plan and pays for the airplane over time. Since the airline will ultimately own the plane, it shows up on its books as an asset, and the lease obligations show up as liabilities.
If the airline sets up an operating lease, the leasing group retains ownership of the plane; therefore, the transaction does not appear on the airline's balance sheet. The lease payments appear as operating expenses instead. Operating leases, which are popular in industries that use expensive equipment, are disclosed in the footnotes of the company's published financial statements.
Consider Federal Express Corp. In its 2004 annual report, the balance sheet shows liabilities totaling $11.1 billion. But dig deeper, and you will notice in the footnotes that Federal Express discloses $XX worth of non-cancelable operating leases. So, the company's total debt is clearly much higher than what's listed on the balance sheet. Since operating leases keep substantial liabilities away from plain sight, they have the added benefit of boosting--artificially, critics say--key performance measures such as return-on-assets and debt-to-capital ratios.
The accounting differences between capital and operating leases impact the cash flow statement as well as the balance sheet. Payments for operating leases show up as cash outflows from operations. Capital lease payments, by contrast, are divided between operating activities and financing activities. Therefore, firms that use capital leases will typically report higher cash flows from operations than those that rely on operating leases.
Building or buying an office building can load up a company's debt on the balance sheet. A lot of businesses therefore avoid the liability by using synthetic leases to finance their property: a bank or other third party purchases the property and rents it to the company. For accounting purposes, the company is treated like a tenant in a traditional operating lease. So, neither the building asset nor the lease liability appears on the firm's balance sheet. However, a synthetic lease, unlike a traditional lease, gives the company some benefits of ownership, including the right to deduct interest payments and the depreciation of the property from its tax bill.
Details about synthetic leases normally appear in the footnotes of financial statements, where investors can determine their impact on debt. Synthetic leases can become a big worry for investors when the footnotes reveal that the company is responsible for not only making lease payments but also guaranteeing property values. If property prices fall, those guarantees represent a big source of liability risk.
Banks and other financial organizations often hold assets--like credit card receivables--that third parties might be willing to buy. To distinguish the assets it sells from the ones it keeps, the company creates a special purpose entity (SPE). The SPE purchases the credit card receivables from the company with the proceeds from a bond offering backed by the receivables themselves. The SPE then uses the money received from cardholders to repay the bond investors. Since much of the credit risk gets offloaded along with the assets, these liabilities are taken off the company's balance sheet.
Capital One is just one of many credit card issuers that securitize loans. In its 2004 first quarter report, the bank highlights results of its credit card operations on a so-called managed basis, which includes $38.4 billion worth of off-balance-sheet securitized loans. The performance of Capital One's entire portfolio, including the securitized loans, is an important indicator of how well or poorly the overall business is being run.
Companies argue that off-balance-sheet techniques benefit investors because they allow management to tap extra sources of financing and reduce liability risk that could hurt earnings. That's true, but off-balance-sheet finance also has the power to make companies and their management teams look better than they are. Although most examples of off-balance sheet debt are far removed from the shadowy world of Enron's books, there are nonetheless billions of dollars worth of real financial liabilities that are not immediately apparent in companies' financial reports. It's important for investors to get the full story on company liabilities.