This means that the business can only use $90,000 of the loan proceeds and must keep $10,000 on deposit with the bank. For the bank, the extra $20,000 compensating balance serves as security for the loan. For the borrower, this extra $20,000 reduces the interest rate they can get on this loan.

• A material amount is defined as an amount large enough to affect the opinion of a person reading a financial statement.
• This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
• When the two sides of the arrangement are netted, the loan is actually $4,750,000.
• Assume a clothing store needs a $100,000 line of credit (LOC) to manage its operating cash flow each month.
• It is a way for banks to ensure that borrowers have a vested interest in repaying their loans and to offset the risk of lending money.

In short, even though they have to pay interest on the compensating balance, the lower interest rate they receive makes this worthwhile. 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. But what if you don’t end up using or accessing your line of credit at all?

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Her expertise is in personal finance and investing, and real estate. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com.

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. 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.

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You won’t get hit with any sudden surprises or fees you weren’t expecting. Plus, you can receive cash balances that fit with what you need, all while staying within the accounting rules. A compensating balance allows lenders to limit that risk and receive collateral in case something happens. The borrower ends up receiving a reduced amount from the lender, but the lender still receives interest on the full amount of the loan.

However, debt finance may also come with some disadvantages. It’s not uncommon for borrowers to commit to a compensating balance without knowing it. Before you take out a loan, be sure to read the fine print and find out whether you’ll be responsible for a compensating balance. 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. Perhaps an offer with a compensating balance provides you with an overall better deal.

Origin of compensating balance

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. A compensating compensating balance definition balance may also benefit you as a borrower because you’ll likely be able to secure a lower interest rate. The bank may require the business to maintain a compensating balance of 10%, or $10,000, in a non-interest-bearing account for the duration of the loan.

Individual loans are less likely to require a compensating balance than corporate loans. Also, it must be disclosed in the borrower’s notes to the financial accounts. 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. There are two main ways of calculating a compensating balance. These are the average balance arrangement and the minimum fixed balance arrangement.

Most customers pay in cash or with a credit card, so the LOC can usually be paid off in the last week of the month. Once the LOC is in place, the furniture store needs to manage cash flow to minimize the interest expense it’s paying for use of the LOC. Assume, https://personal-accounting.org/bond-definition/ for example, the interest rate on the LOC is an annualized rate of 7% and the store starts the month with a $35,000 cash balance. The store estimates sales for the month to be $90,000, and $50,000 in inventory needs to be purchased to meet customer demand.