Why A/R Securitization Can Distort the True Picture of a Companys Financial Health

September 1, 2003, By Dean Kaplan One common form of off-balance sheet financing is an accounts receivable securitization financing program. In this program, a company transfers most of its accounts receivable to a trust, where it is not available to general creditors. The financing source then buys a majority ownership stake in the trust while the company retains a small ownership stake. Since the company has sold its ownership of the receivables, the value of the sold receivables should not be reflected on its balance sheet. Since it was a sale, not a loan, the money received from the financing source should not be considered a loan, and therefore no liability should be recorded on the companys balance sheet. Only receivables not transferred to the trust or the companys ownership interest in the trust appear on the companys balance sheet, along with the cash they got at the time of the sale. There is nothing sinister about this form of financing. In fact, it is a relatively low-cost method of raising capital. Typically, the notes to financial statements include complete disclosure of the transaction. However, the structure of the transaction can cause the resulting balance sheet to tell less than the whole story. In Table 1, we see a summary balance sheet, as reported in a public companys 10Q filing. The original balance sheet shows the companys debt-to-equity ratio was .29, which indicates low leverage and plenty of debt capacity, if required. The accounts receivable balance of $2.35 billion does not include $910 million that was sold in a securitization program. But consider this: If the company had retained ownership of all its receivables and simply borrowed $910 million, then both receivables and debt on the companys balance sheet would be $910 million higher than that reported in the financial statements. These adjustments are shown in the adjustment column along with an adjusted pro-forma balance sheet. The adjustment column also eliminates goodwill so that the debt-to-tangible equity ratio can be calculated. The

resulting pro-forma balance sheet shows a debt-to-tangible equity ratio of 1.0, which casts a very different light on the companys debt levels and borrowing capacity. Securitizations Impact on DSO

The exclusion of the sold receivables from the balance sheet also distorts the calculation of efficiency ratios such as DSO. Chart 2 shows how DSO, based on published balance sheets, appears to drop after A/R are securitized. In this case, DSO improved from approximately 65 days to 55 days after a securitization. However, when receivables sold as part of the financing program are added back, we see that there has been no improvement in DSO management over this time frame. Just because a transaction is an off-balance sheet type doesnt make it bad. However, it does mean the balance sheet may not tell the whole story. Dean Kaplan is a Partner in The Kaplan Group, 805541-2639.