What Is a Compensating Balance?
A compensating balance is a minimum deposit that must be maintained in a bank account by a borrower.
The requirement for a compensating balance is most common with corporate rather than individual loans. The borrower cannot use the money but is required to disclose it in the borrower’s notes attached to its financial statements.
- Agreeing to a compensating balance allows a company to borrow money at a favorable rate of interest.
- The compensating balance offsets the bank's default risk and can be used to make new loans.
- The business borrower must report the compensating balance in its financial statements, typically as restricted cash.
How Compensating Balances Work
The borrower who agrees to hold a compensating balance promises the lender to maintain a minimum balance in an account. The bank is free to use the compensating balance in loans made to other borrowers.
The compensating balance is usually a percentage of the loan total. The funds are generally held in a deposit account such as a checking or savings account, a certificate of deposit (CD), or another holding account.
For the borrower, the compensating balance is a mixed blessing. The loan generally will come at a lower rate of interest. However, the borrower must pay interest on the full amount of the loan, including the balance that may not be spent.
A loan with a compensating balance may be extended to an individual or a company with a poor credit rating. Those applicants might otherwise be charged higher interest rates or be turned down for a loan.
The compensating balance cuts down on the risk to the lender by allowing for recovery of part of the loan in cases of default.
Accounting Rules on Compensating Balances
Accounting rules for financial reporting require that compensating balances be reported separately from cash balances in the borrowers' financial statements if the dollar amount of the compensating balance is material. A material amount is defined as an amount large enough to affect the opinion of a person reading a financial statement.
Compensating balances are generally reported on financial statements as restricted cash. Restricted cash is money that is allocated for a set purpose and is thus not available for immediate or general business use.
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 to use the LOC to purchase inventory at the beginning of the month, and then pay down the balance with money brought in by sales throughout the month.
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, profiting on the difference between the interest it earns 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 to minimize the interest expense it's paying for use of the LOC.
Agreeing to a compensating balance may allow a company to borrow at a favorable rate of interest.
Assume, for example, the interest rate on the LOC is an annualized 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. Most customers pay in cash or with a credit card, so the LOC can usually be 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.