Capital Structure Decisions: Evaluating Risk and Uncertainty

Chapter Six

Role of Off–Balance Sheet Capital

OFF–BALANCE SHEET ITEMS ARE strategic capital investments that hedge risk and provide capital support to a firm. Capital is primarily necessary for the operations of the firm; it provides a risk cushion, and it incentivises future expectations. Through its operations, a firm generates several contingent claims to support the need for operational, risk, and signaling capital. Such contingent claims do not directly support the firm’s operations, but they provide strategic value to a firm’s ROE and ROA by reducing the burden of balance sheet liabilities. Instruments of off–balance sheet capital have earned themselves a bad name, with the mismanagement of such capital by Enron, Barring Banks, and others. It is undeniable that such capital adds strategic value by securing value-added risk, if and only if it is managed properly

Most off–balance sheet items are recognised with insurance covers and derivative products, as mentioned in the previous chapter. Such instruments support only the passive and value-added risk of a firm. Off–balance sheet capital is beyond the use of such instruments. It uses contingent claims on financial contracts to support investments in fixed assets, provides for working capital, supplies risk-management tools for selective exposures, and also offers incentive schemes for a firm’s management and signaling capital. Innovations of leasing, hire purchase, factoring, revolving credits, derivatives, insurance covers, ...