CFA Level 1

AAA

Liabilities - Effects Of Off-Balance Sheet Financing Transactions On Financial Ratios

  • Take-or-pay contracts and throughput agreements
    These types of agreements effectively allow companies to keep some operation assets and liabilities off the balance sheet. As a result, in the analysis of a company's financial statement, the balance sheet should be restated and include the present value of the minimum future payments to both the assets and liabilities section of the balance sheet. If this is not done, the debt-to-equity and asset-turnover ratio will be overstated.
  • Sales of receivables
    Sales of receivables artificially reduce the receivables and short-term borrowing needs. Furthermore, they distort the pattern of cash flow from operations as the firm receives cash earlier than it would if the receivables had been collected in due course.

    In addition, the potential liability associated with the buyer-recourse provision is not displayed on the balance sheet. From an analytical point of view, the current-asset ratio, working capital and receivable turnover will be overstated.

    On the other hand, the leverage ratios such as debt-to-equity will be too high. The reported income will also be too high because if it did not sell its receivables, the company would have had to borrow the funds it acquired from the sale of the receivables to finance its current operations.

    Analysts should adjust the balance sheet by adding back the amount of accounts receivables sold and increase short-term borrowing by an equal amount. Furthermore, the income statement needs to be restated and include the interest expense that would have been incurred by the firm had it not sold its receivables and borrowed the money instead.

Accounting For Leases
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