What Is a Compensating Balance?
A compensating balance is a base deposit that must be kept up with in a bank account by a borrower.
The requirement for a compensating balance is generally common with corporate instead of individual loans. The borrower can't utilize the money however is required to reveal it in the borrower's notes appended to its financial statements.
How Compensating Balances Work
The borrower who consents to hold a compensating balance guarantees the lender to keep a base balance in an account. The bank is free to involve the compensating balance in loans made to different borrowers.
The compensating balance is typically a percentage of the loan total. The funds are generally held in a deposit account, for example, a checking or savings account, a certificate of deposit (CD), or another holding account.
For the borrower, the compensating balance is a mixed gift. The loan generally will come at a lower rate of interest. In any case, 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 might be extended to an individual or a company with a poor credit rating. Those candidates could somehow be charged higher interest rates or be turned down for a loan.
The compensating balance cuts down on the risk to the lender by considering recovery of part of the loan in instances 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 assuming the dollar amount of the compensating balance is material. A material amount is defined as an amount sufficiently large to influence the assessment of a person perusing 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 hence not accessible for immediate or general business use.
Figuring in Inventory Purchases
Expect a dress store needs a $100,000 credit extension (LOC) to deal with its operating cash flow every month. The store plans to utilize the LOC to purchase inventory toward the beginning of the month, and afterward pay down the balance with money brought in by sales over time.
The bank consents to charge a lower interest rate on the LOC in the event that the dress store deposits a $30,000 compensating balance.
The bank loans the apparel store's compensating balance to different borrowers, benefitting on the difference between the interest it acquires and the lower rate of interest paid to the attire store.
Instances of Cash Management
When the LOC is in place, the apparel store necessities to oversee cash flow to limit the interest expense it's paying for utilization of the LOC.
Consenting to a compensating balance might permit a company to borrow at an ideal rate of interest.
Expect, for instance, the interest rate on the LOC is an annualized rate of 6% and the store begins the month with a $20,000 cash balance. The store gauges sales for the month to be $50,000, and $40,000 in inventory should be purchased to fulfill customer need.
Since the store needs the $20,000 cash balance for different 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 generally be paid off in the last seven day stretch of the month.
The store causes an interest expense at a 6% annual rate on the $40,000, and the owner keeps on borrowing from the LOC toward the beginning of every month to purchase inventory.
- The business borrower must report the compensating balance in its financial statements, regularly as restricted cash.
- Consenting to a compensating balance permits a company to borrow money at a positive rate of interest.
- The compensating balance offsets the bank's default risk and can be utilized to make new loans.