What Is a Compensating Balance in Finance and How Does It Work?
Learn how compensating balances work in finance, their role in loan agreements, and how they impact liquidity, interest earnings, and financial reporting.
Businesses and individuals sometimes need to maintain a specific amount of money in their bank accounts as part of a loan agreement. This requirement, known as a compensating balance, is often tied to loans or lines of credit. While it may seem like just another banking condition, it has financial implications for both borrowers and lenders.
Purpose in Loan Arrangements
Lenders require compensating balances to reduce risk and ensure borrowers maintain liquidity. These funds act as collateral, providing financial institutions with additional security. This is common in business loans, where lenders want assurance that companies can meet their obligations.
For borrowers, this requirement affects cash management. Since the reserved funds cannot be freely used, businesses must carefully plan working capital. If a company does not account for the restricted funds, it may struggle with short-term expenses like payroll, inventory purchases, or rent.
From the lender’s perspective, compensating balances help offset the cost of providing credit. Banks use these deposits to fund other loans or investments, generating returns that help balance lending risks. This is particularly relevant for lower-interest loans, where banks may not earn enough from interest payments alone.
Key Structures
Compensating balances vary based on loan agreements, determining how much money must be kept in reserve, how it is maintained, and whether it earns interest.
Minimum Deposit
Lenders typically require borrowers to maintain a minimum deposit, often expressed as a percentage of the loan or credit line. For example, a bank may require a business to keep 10% of a $500,000 loan in a separate account, meaning $50,000 must remain untouched.
The percentage varies based on factors such as the borrower’s creditworthiness, loan type, and lender policies. A financially stable company may negotiate a lower percentage, while a riskier borrower might be required to maintain a higher balance. If the balance falls below the required amount, the lender may impose penalties, such as higher interest rates or additional fees. In some cases, failing to maintain the minimum deposit could even trigger a loan default.
Linked Deposit Terms
The terms governing a compensating balance dictate how long the funds must remain in the account and whether they can fluctuate. Some agreements require the balance to be maintained throughout the entire loan term, while others allow adjustments based on the outstanding loan amount.
For example, if a business has a revolving line of credit, the required balance might be tied to the amount currently borrowed rather than the total credit limit. If the company borrows $200,000 from a $500,000 credit line and the compensating balance is set at 10%, it would need to keep $20,000 in reserve. If the borrowing increases to $300,000, the required balance would rise to $30,000.
Lenders may also restrict withdrawals, preventing businesses from accessing the funds even if they temporarily exceed the required balance. This can create cash flow challenges, particularly for companies with seasonal revenue fluctuations.
Interest Earnings
Whether a compensating balance earns interest depends on the agreement. Some banks allow these funds to accrue interest at a standard savings or money market rate, while others keep them in non-interest-bearing accounts.
If interest is paid, it is usually at a lower rate than what the borrower is charged on the loan. For example, a business might pay 6% interest on its loan while earning only 1% on the compensating balance. This difference increases the effective cost of borrowing.
If no interest is earned, the opportunity cost becomes more significant. The business could have otherwise invested the money in higher-yielding assets or used it for operations. Some companies negotiate better terms, such as placing the balance in an interest-bearing account or using it to offset banking fees, but lenders may be reluctant to offer concessions.
Accounting Treatment
Under U.S. Generally Accepted Accounting Principles (GAAP), specifically ASC 210-10-45, compensating balances that are legally restricted due to a lending agreement must be reported separately from unrestricted cash. If the restriction extends beyond one year, the balance should be classified as a non-current asset on the balance sheet; otherwise, it remains a current asset if the restriction is expected to be lifted within the operating cycle.
From a tax perspective, compensating balances are not deductible as an expense since they are not an outright cost but rather a borrowing condition. While interest paid on a loan is deductible under IRC Section 163, the opportunity cost of keeping funds in a restricted account is not.
On cash flow statements, compensating balances impact the operating and financing activities sections. If the balance is required as part of a loan agreement, changes in the restricted cash account are reported under financing activities. If the balance is tied to a short-term obligation or fluctuates frequently, it may be classified under operating activities. Proper classification ensures compliance with ASC 230, which governs cash flow presentation.
Disclosure Requirements
Publicly traded companies and certain private entities must disclose compensating balances in financial statements to ensure transparency for investors and regulators. Under SEC Regulation S-X, Rule 5-02, businesses must present restricted cash separately on the balance sheet if the amount is material.
Beyond balance sheet presentation, companies must provide footnote disclosures explaining the nature and terms of these balances. Financial Accounting Standards Board (FASB) ASC 860-30 requires entities to describe restrictions on cash, including withdrawal limitations, restriction duration, and penalties for non-compliance. These disclosures are particularly relevant for credit agreements that impose restrictive covenants, as investors need to understand how such conditions impact operations.
Example Calculation
To understand how a compensating balance affects borrowing costs, consider a business that secures a $1,000,000 loan with a 6% annual interest rate. The lender requires a 15% compensating balance, meaning the company must keep $150,000 in a restricted account. While the loan principal remains $1,000,000, the effective amount available for use is only $850,000.
The business still pays interest on the full loan amount, resulting in an annual interest expense of $60,000 ($1,000,000 × 6%). However, since only $850,000 is accessible, the effective interest rate increases. To calculate this, divide the total interest expense by the usable funds:
$60,000 ÷ $850,000 = 7.06%
This means the true cost of borrowing is higher than the stated rate. If the compensating balance earns interest at 1%, the business receives $1,500 annually ($150,000 × 1%), slightly offsetting the cost. However, the net borrowing rate remains elevated at 6.88% ($60,000 – $1,500) ÷ $850,000.