Why do many companies find off-balance-sheet financing attractive? How might a company’s investors bondholders and stockholders react?
Off-balance-sheet is attractive to many companies because it permits them to publish financial statements which present the firm as stronger than it really is. Leaving the debt off the right-hand side of the balance sheet lowers the firm’s reported financial leverage. Omitting the proceeds from the financing from the left-hand side of the balance sheet increases reported profitability measures based on assets such as return on assets and basic earning power. Investors who are unaware of the off-balance-sheet financing have no basis for reacting to it. However, to the extent that a company’s investors learn of its off-balance-sheet financing activities¾from the footnotes to the firm’s financial statements, from analysts, or from the financial press¾they will react on one of several ways. First, they will recast the firm’s financial statements to include the missing financing in order to better understand the company’s financial health. If they believe the company still to be strong, and especially if they think that the company has successfully used the off-balance-sheet financing to lower its funding costs, they will most likely approve of it and accord the company a higher market value. On the other hand, if they discover that the company is not as strong as they believed, they will likely consider themselves the victims of misrepresentation and lower the company’s market value.
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