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. Effectively it acts as collateral and thus compensates the lender for the risk of making the loan.
Why do lenders ask for compensating balances?
A compensating balance effectively changes the risk versus reward balance in favour of the lender. The lender pays a reduced amount to the borrower, but receives interest on the full amount of the loan.
Why do borrowers agree to a compensating balance?
Some borrowers may have no real choice. Businesses have to build up a credit history, just like private individuals. And as with private individuals, this process takes time. What’s more, it can be set back as a result of both misguided decisions and unforeseen circumstances.
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.
Some borrowers may accidentally end up agreeing to a compensating balance because they did not read, or fully understand their loan agreement. This highlights the importance of making sure that you really understand a contract before you sign it. If necessary, get a professional to explain it to you.
How is a compensating balance calculated?
There are two main ways of calculating a compensating balance. These are the average balance arrangement and the minimum fixed balance arrangement. The former tends to be used for lines of credit and the latter for instalment loans.
The average balance arrangement requires a borrower to ensure that they maintain a minimum average balance over an agreed period. This is usually 30 days. 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.
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.
An example of a compensating balance arrangement
Hotshot Fashions needs a $100K line of credit. Smith’s Bank offers to provide a $110K line of credit with a $10K compensating balance on the average balance arrangement. Hotshot Fashions, therefore, has to pay interest on $10K each month, regardless of whether or not it accesses the line of credit. If it does access the line of credit it pays interest on what it borrows plus the $10K compensating balance.
The fashion company also needs an instalment loan for $100K. 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.
Accounting for a compensating balance
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.
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.
A company may choose to specify the purpose or purposes of the restricted cash in its main balance sheet. It is, however, also perfectly acceptable to include this information as part of the footnotes.
How we can help
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.