What is a 'Compensating Balance'

A compensating balance is a minimum balance that must be maintained in a bank account, and the compensating balance is used to offset the cost incurred by a bank to set up a business loan. The compensating balance is not available for company use, and may need to be disclosed in the borrower’s notes to the financial statements. The bank is free to loan the compensating balance to other borrowers and profit from differences between the interest rates.

BREAKING DOWN 'Compensating Balance'

By requiring money to be deposited to offset some of a loan's cost, the bank is able to extend other loans and pursue other investment opportunities, while the business is charged a lower interest rate on a loan.

How Compensating Balances Are Disclosed

Accounting rules require the compensating balance be reported separately from the cash balance in the borrower’s financial statements, if the dollar amount of the compensating balance is material. A material amount is a dollar amount large enough to impact the opinion of the financial statement reader.

Factoring in Inventory Purchases

Assume a clothing store needs a $100,000 line of credit (LOC) to manage its operating cash flow each month. The store plans on using the LOC to make inventory purchases at the beginning of the month, and then pay down the balance as the store generates sales. The bank agrees to charge a lower interest rate on the LOC if the clothing store deposits a $30,000 compensating balance. The bank loans the clothing store’s compensating balance to other borrowers, and profits on the difference between the interest earned and the lower rate of interest paid to the clothing store.

Examples of Cash Management

Once the LOC is in place, the clothing store needs to manage cash flow so the business can minimize the interest expense paid on the LOC borrowings. Assume, for example, the interest rate on the LOC is an annual rate of 6% and the store starts the month with a $20,000 cash balance. The store estimates sales for the month to be $50,000, and $40,000 in inventory needs to be purchased to meet customer demand. Since the store needs the $20,000 cash balance for other expenses, the owner borrows $40,000 from the LOC to purchase inventory. Nearly all customers pay in cash or with a credit card, so the store collects cash quickly, and the LOC is paid off in the last week of the month. The store incurs an interest expense at a 6% annual rate on the $40,000, and the owner continues to borrow from the LOC at the beginning of each month to purchase inventory.

RELATED TERMS
  1. Line Of Credit - LOC

    An arrangement between a financial institution, usually a bank, ...
  2. Readvanceable Mortgage

    A mortgage feature that allows the borrower to re-borrow the ...
  3. New Balance

    The new balance is the sum of your previous balance, payments, ...
  4. Minimum Balance

    The minimum dollar amount that a customer must have in an account ...
  5. Roll In

    A term which refers to including loan costs into the initial ...
  6. Average Outstanding Balance

    The unpaid, interest-bearing balance of a loan or loan portfolio ...
Related Articles
  1. Small Business

    Letter of Credit

    A letter of credit is a document from a bank promising to pay the holder a certain amount if the holder fulfills certain obligations. Sellers in commercial transactions often require buyers to ...
  2. Investing

    Analyzing A Bank's Financial Statements

    A careful review of a bank's financial statements can help you identify key factors in a potential investment.
  3. Personal Finance

    Calculating Interest Expense

    Interest expense is the cost of borrowing money.
  4. Personal Finance

    8 Top Alternatives to Car Title Loans

    Before you sign up for a car title loan, investigate these 8 alternate strategies.
  5. Investing

    5 Retailers Set to Close More Stores in 2016 (FINL, GPS)

    Discover retail stores that have already announced plans to close stores in 2016. Some expect a new economic downturn, which may lead more stores to close.
  6. Investing

    99 Cents Only Stores Profits Edge Up

    Dollar retailer 99 Cents Only increased revenue and profits despite product-cost increases.
  7. Personal Finance

    How Banks Set Interest Rates on Your Loans

    Many factors go into how banks set interest rates for loans. Use this information to negotiate the best possible rate when you're borrowing.
  8. Personal Finance

    Store Credit Card Traps To Avoid

    Retail credit cards may seem like a good idea, but they can create enormous debt problems in the future.
  9. Personal Finance

    Understanding Term Loans

    A loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate.
  10. Personal Finance

    Simple Interest Loans: Do They Exist?

    Yes, they do. Here is what they are – and how to use them to your advantage.
RELATED FAQS
  1. What is the difference between a balance sheet and a cash flow statement?

    Understand the difference between a balance sheet and an income statement. Learn the three components of each of the financial ... Read Answer >>
  2. When is a balance transfer a good idea for paying off debt?

    Learn the best situation in which to do a balance transfer, enabling you to pay off your credit card debt more quickly while ... Read Answer >>
Trading Center