Compensating Balance

A compensating balance is a minimum balance that must be maintained in a bank account, used to offset the cost incurred by a bank to set up a business loan. The compensating balance is not available for company use, and may need to be disclosed in the borrower’s notes to the financial statements. The bank is free to loan the compensating balance to other borrowers and profit from differences between the interest rates.

By requiring money to be deposited to offset some of a loan's cost, the bank is able to extend other loans and pursue other investment opportunities, while the business is charged a lower interest rate on a loan.

Accounting rules require the compensating balance be reported separately from the cash balance in the borrower’s financial statements if the dollar amount of the compensating balance is material. A material amount is a dollar amount large enough to affect the opinion of the financial statement reader.

Assume a clothing store needs a $100,000 line of credit (LOC) to manage its operating cash flow each month. The store plans on using the LOC to make inventory purchases at the beginning of the month, and then pay down the balance as the store generates sales. The bank agrees to charge a lower interest rate on the LOC if the clothing store deposits a $30,000 compensating balance. The bank loans the clothing store’s compensating balance to other borrowers, and profits on the difference between the interest earned and the lower rate of interest paid to the clothing store.

Once the LOC is in place, the clothing store needs to manage cash flow so the business can minimize the interest expense paid on the LOC borrowings. Assume, for example, the interest rate on the LOC is an annual 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. Since the store needs the $20,000 cash balance for other expenses, the owner borrows $40,000 from the LOC to purchase inventory. Nearly all customers pay in cash or with a credit card, so the store collects cash quickly, and the LOC is paid off in the last week of the month. The store incurs 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.