For most companies or businesses, obtaining loans is essential in continuing operations. These loans constitute debt finance for them. There are several benefits that come with this finance source. For example, companies can tax advantages when paying interest on debt finance. However, debt finance may also come with some disadvantages.
Every company uses debt finance as a part of its capital structure. This debt may come from several providers. Most commonly, however, companies obtain debt from financial institutions, such as banks. Depending on the type of loan arrangement they enter into, borrowers have to meet some criteria. These criteria may also differ according to the lender a company chooses. One such condition comes in the form of a compensating balance.
What is a Compensating Balance?
Compensating balance is a term used to describe the minimum balance that borrowers must maintain for their loan accounts. For the lender, the compensating balance serves as a way to reduce its lending costs. Lenders can use this amount to reinvest in other ventures or keep some or all of the proceeds. This limit may differ according to each lender’s requirements.
It is also beneficial for the borrower. Usually, when the borrower agrees to a minimum balance, they receive better interest rates. Therefore, they can reduce their overall expense by maintaining this minimum balance in their account. However, it may take the effective interest rate of the loan higher.
How does a Compensating Balance work?
When obtaining a loan, borrowers agree to various terms associated with it. Most lenders introduce these terms to ensure the credit risk for their transactions is minimum. For example, lenders may require borrowers to provide security. One such requirement comes in the form of a compensating balance. In this term, the lender requires borrowers to hold a minimum balance in an account.
The lender can use this amount at their discretion. For example, lenders may use it to provide further loans to other borrowers. For the borrower, however, a compensating balance is restricted funds. The borrower cannot access these funds until the loan’s maturity. Usually, borrowers set the compensating balance as a percentage of the total loan value.
Lenders require borrowers to hold this balance in a deposit account. For the lender, it serves as a type of security. It also decreases the risks associated with default for the lender. For the borrower, it reduces the interest rate for the loan. However, borrowers have to pay interest on the entire amount of the loan. It can drive their expenses upwards.
What is the Accounting for a Compensating Balance for the Borrower?
A compensating balance is an amount that borrowers must maintain in their accounts. However, they cannot use this amount. While compensating balance requirements may apply to both individuals and companies, it is most prevalent for companies. Therefore, companies that borrow a loan with a compensating balance must account for it accordingly.
When accounting for compensating balance, companies must understand that they cannot use it. However, they must still present this information to their stakeholders. Therefore, companies must disclose the compensating balance requirement in the financial statements as a disclosure in the notes. This disclosure covers the accounting for compensating balances.
If it is material, the borrower must present it separately from other cash balances. Even if it does not constitute a material balance, it is good practice for borrowers to disclose this amount separately. Borrowers need to list this balance under restricted cash in the balance sheet. It allows users of the financial statements to understand the amount may not be available for use.
What is an Example of Compensating Balance?
A company, ABC Co., applies for a loan at a bank. The company requires at least a $200,000 line of credit facility to finance its operations. The bank agrees to provide this loan but also requires a 10% compensating balance. Therefore, ABC Co. must obtain a $220,000 loan from the bank. In this amount, ABC Co. must always maintain a $20,000 balance at the bank.
For the bank, the extra $20,000 compensating balance serves as security for the loan. In essence, the bank is still providing $200,000 as a loan. For the borrower, this extra $20,000 reduces the interest rate they can get on this loan. However, they also have to bear extra interest on the additional $20,000 balance. This increase can lead to an overall rise in the borrower’s costs.
A compensating balance is a loan term that requires borrowers to maintain a specific balance with the lender. This additional balance serves as security for the lender and can help borrowers secure lower interest rates. However, the borrower cannot access these funds until the loan’s maturity. Borrowers must disclose any compensating balance in their financial statements.