What Is a Compensating Balance?
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 interest rates.
How Compensating Balances Work
Compensating balances can be held by individuals, but is most common with corporate loans. When a borrower agrees to hold a compensating balance, it promises a lender to maintain a minimum balance in an account.
The compensating balance required by a lender is usually a percentage of the loan balance. 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.
By requiring money to be deposited to offset some of the costs of a loan, 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. This also increases the cost of capital for the borrower. That's because the borrower doesn't have access to the full amount of the loan, but is still charged interest on the entire balance.
There may be different reasons why a lender requires a borrower to hold a compensating balance before issuing a loan. A consumer may have a low or poor credit rating or a company may be in financial duress. Either way, a compensating balance cuts down on the risk to the lender, and also provides surety that some of the funds may be recovered in case the borrower defaults on the loan.
Disclosing Compensating Balances
Accounting rules require compensating balances be reported separately from cash balances in borrowers' financial statements if the dollar amount of the compensating balance is material. A material amount is a dollar amount large enough to affect the opinion of a person reading a financial statement.
Compensating balances must be reported separately from cash balances on the borrower's financial statements.
Compensating balances are generally reported on financial statements as restricted cash. Restricted cash is money held by a company for a certain purpose and, therefore, is not available for immediate or for general business use.
- A compensating balance is a minimum balance held in a bank account to offset the cost a bank incurs to set up a loan.
- The balance cannot be used by the company, although the lender may lend it to others.
- The compensating balance is generally a percentage of the loan.
- This balance reduces the cost of lending, but may increase the borrower's cost of capital.
- The borrower must report the compensating balance in its financial statements separate from other cash balances, typically as restricted cash.
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 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.