What is a Compensating Balance?

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. Agreeing to a compensating balance may allow a company to borrow at a favorable rate of interest.

• Since the store needs the $20,000 cash balance for other expenses, the owner borrows $40,000 from the LOC to purchase inventory.
• The borrower may also benefit from being granted a somewhat lower interest rate.
• Perhaps an offer with a compensating balance provides you with an overall better deal.
• Hotshot Fashions, therefore, has to pay interest on $10K each month, regardless of whether or not it accesses the line of credit.
• The borrower cannot use the money but is required to disclose it in the borrower’s notes attached to its financial statements.

If you’re interested in finding out more about compensating balances, then get in touch with the financial experts at GoCardless. Find out how GoCardless can help you with ad hoc payments or recurring payments. The borrowing agreement states that the corporation will maintain a compensating balance in an account at the bank of at least $250,000. When the two sides of the arrangement are netted, the loan is actually $4,750,000. The bank agrees to charge a lower interest rate on the LOC if the clothing store deposits a $30,000 compensating balance. Assume a clothing store needs a $100,000 line of credit (LOC) to manage its operating cash flow each month.

Related Terms

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. For the borrower, the compensating balance is a mixed blessing.

In principle, compensating balances only need to be reported separately from regular cash balances if the compensating balance is ‘material’. That is to say, if it could influence the judgement of a person reading the company’s financial statements. The minimum fixed balance arrangement is exactly what it sounds like. The borrower must keep an agreed minimum balance with the lender at all times.

How a Compensating Balance Works

It’s intended to reduce the cost of lending for the lender because it allows them to invest the cash in the compensating balance account and keep all or a portion of the proceeds. A compensating balance may also benefit you as a borrower because you’ll likely be able to secure a lower interest rate. A borrower who has entered into a compensating balance arrangement may need to disclose this situation in the footnotes to its financial statements, if the amount is material. 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.

• The store estimates sales for the month to be $50,000, and $40,000 in inventory needs to be purchased to meet customer demand.
• Agreeing to a compensating balance may allow a company to borrow at a favorable rate of interest.
• Often, you’re forced to accept a compensating balance as a borrower.
• Restricted cash can include minimum balances on bank accounts, while compensating balances include money needed to repay a loan.
• ABC Bank offers you a $70,000 line of credit with a $10,000 compensating balance.
• Compensating balance is a balance that must be held with a lender in order for a borrower to be eligible for an installment loan or line of credit.

Also, when you take out a loan with a compensating balance, you must report the balance as “restricted cash” in your financial statements. Restricted cash refers to money that is reserved for a specific purpose and not available for general or immediate business use. If your agreement has an average balance agreement, you must maintain a minimum average balance over an agreed-upon term, which is typically 30 days.

Why do lenders ask for compensating balances?

However, the borrower must pay interest on the full amount of the loan, including the balance that may not be spent. Smith’s Bank offers to lend them $110K with a $10K minimum fixed compensating balance. Hotshot Fashions, therefore, has to pay interest on a $110K loan to get the $100K loan it actually needs. Some borrowers may agree to leave a compensating balance because it provides them with a better overall deal. In short, even though they have to pay interest on the compensating balance, the lower interest rate they receive makes this worthwhile. Learn the definition of a classified balance sheet and understand how to prepare classified balance sheets.

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. Various adjustments are done in the financial statements due to regular operations and transactions https://personal-accounting.org/retained-earnings-definition/ that happen or on go in the business. These adjustments can be of anything ranging from the bad debts to the adjustment in machinery account, etc. Let’s take a closer look at what a compensating balance is and how it works, so you can understand how it may apply to your situation.