What Is a Compensating Balance?

A compensating balance is a minimum bank account balance that a borrower agrees to maintain with a lender. The lender requires this arrangement in exchange for lending funds to the borrower. The amount of funds to be held at the bank is typically set at a percentage of the loan balance. A material amount is defined as an amount large enough to affect the opinion of a person reading a financial statement. 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.

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What Is a Compensating Balance and How It Impacts Your Loan Costs

1. Just like your individual credit, you also need to build up a solid credit history with your business.
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3. Your business is looking to take out a line of credit for the amount of $50,000.
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5. In addition to loans, a compensating balance approach may be used to secure a line of credit.

However, this depends on the lender’s policies and the specific circumstances of the loan. ABC Bank offers you a $70,000 line of credit with a $10,000 compensating balance. In this situation, you’ll be on the hook for that $10,000 each month, whether you access the line of credit or not.

What is a compensating balance?

The store incurs asset retirement obligation definition 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. Agreeing to a compensating balance may allow a company to borrow at a favorable rate of interest. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. Have you ever taken out an instalment loan before or tried to qualify for a line of credit? Or are you just now looking into what some of your options are and came across a few terms you aren’t familiar with?

The borrower, therefore, has the flexibility to use the whole line of credit for part of this period. They must, however, ensure that the money is repaid within the agreed time frame. Yes, a compensating balance is classified as a current asset in accounting because it is money that the company holds in a bank account.

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If you do withdraw funds from the line of credit, you’ll be responsible for the interest on what you borrow plus the $10,000 compensating balance. The balance you agree to maintain with a lender as a borrower is known as a compensating balance. 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. 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 borrower ends up receiving a reduced amount from the lender, but the lender still receives interest on the full amount of the loan. In this example, we assume a nominal interest rate—the percentage that a lender charges on the total loan amount, expressed as a yearly rate—of 10%. This figure is chosen for illustrative purposes to make the math easy to follow and to clearly demonstrate how a compensating balance impacts the true cost of borrowing. Often, you’re forced to accept a compensating balance as a borrower. Maybe you’re a new small business and don’t have a credit history, so this is your only option.

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. Compensating balances are generally reported on financial statements as transactions restricted cash. Restricted cash is money that is allocated for a set purpose and is thus not available for immediate or general business use. 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. A compensating balance is a balance that must be kept with a lender in order for a borrower to qualify for a line of credit or instalment loan.

While it technically belongs to the borrower, they can’t use it freely; it must stay in the account, serving as a guarantee for the lender. 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. Yes, the terms of a compensating balance can often be negotiated as part of the loan agreement. In some cases, borrowers with strong credit or a solid relationship with the lender may be able to negotiate a lower compensating balance or even have it waived entirely.

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However, it’s important to remember that this money is restricted—it cannot be used freely by the company because it must stay in the account as part of the loan agreement. In practice, the safest option is to separate out any compensating balances and let the reader decide for themselves whether or not they are material. For this reason, it’s standard to list compensating balances under ‘restricted cash’. This shows readers that the cash is being set aside for a specific purpose rather than being available for general use.

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When the two sides of the arrangement are netted, the loan is actually $4,750,000. This calculation reveals that while the nominal interest rate is 10%, the actual cost of borrowing—considering the funds that are tied up in the compensating balance—is 12.5%. This higher effective interest rate reflects the fact that the borrower is paying interest on the full loan amount, even though they only have access to $80,000 of it. It plays a crucial role in many loan arrangements, affecting both borrowing costs and a company’s financial strategy. 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.