6 5 Cash, cash equivalents, and restricted cash

For example, companies can tax advantages when paying interest on debt finance. The bank agrees to charge a lower interest rate on the LOC if the clothing store deposits a $30,000 compensating balance. For example, it’s used to meet short term obligations such as operating expenses. Cash is also considered a nonearning asset, so management is constantly balancing the need to hold cash with the desire to put it to work.

  • 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.
  • A material amount is defined as an amount large enough to affect the opinion of a person reading a financial statement.
  • Her expertise is in personal finance and investing, and real estate.
  • We hope this blog post has provided you with valuable information on the topic of compensating balance.

But what if you don’t end up using or accessing your line of credit at all? You would still pay interest each month on your compensating balance of $10,000. But, if you do use your line of credit, you then pay interest on whatever amount you borrow, plus the compensating balance.

Nonelective Contribution: Definition And Benefits To Employees

In this post, we will explore the concept of compensating balance, its definition, examples, and accounting rules. If you’ve ever wondered about the role of compensating balance in managing your finances, you’re in the right place! Since the store needs the $20,000 cash balance for other expenses, the owner borrows $40,000 from the LOC to purchase inventory. Assume a clothing store needs a $100,000 line of credit (LOC) to manage its operating cash flow each month.

Compensating balance is commonly used for commercial accounts, primarily businesses and corporations, rather than individual consumers. This requirement serves as a tool for the bank to manage risk and can provide benefits to the customer based on the terms negotiated with the bank. ABC Bank offers you a $70,000 line of credit with a $10,000 compensating balance.

compensating balance

To keep things simple, a compensating balance acts as collateral for lenders and helps to compensate for any risks. This allows them to pay out a lower amount, but still receive the full amount of interest on the loan or line of credit. Be sure to check with your bank or lender to see what their compensating balance arrangements are. An average balance arrangement is usually used for lines of credit. A minimum fixed balance arrangement tends to be more common for things like instalment loans. Compensating balance is a term used to describe the minimum balance that borrowers must maintain for their loan accounts.

Cash Management

Accounting standards demand that compensating balances be recorded separately from cash balances in the borrowers’ financial statements. A significant amount is one that is large enough to sway a person reading a financial statement’s opinion. As a result, compensating balances are typically shown as restricted cash on financial statements. Hence, it is unavailable for immediate or general business usage is referred to as restricted cash. The financial accounting term restricted cash and compensating balances refers to monies that are reserved and not generally available to the company.

Subordinated Debt: Definition – Overview – Explanation

A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. Compensating errors occur when errors in equal amounts but opposite in effect are made https://personal-accounting.org/retained-earnings-definition/ in different accounts. To correct compensating errors, each error must be corrected individually. When an already-committed error is offset by another error (or set of errors), the latter error is known as a compensating error.

It is essential for businesses to account for the compensating balance correctly to maintain accurate financial statements and meet regulatory standards. If your agreement has an average balance agreement, you must maintain a minimum average balance over an agreed-upon term, which is typically 30 days. With a minimum fixed balance, you’ll be required to always keep an agreed minimum balance with the lender. The borrowing agreement states that the corporation will maintain a compensating balance in an account at the bank of at least $250,000. When the two sides of the arrangement are netted, the loan is actually $4,750,000. A borrower who has entered into a compensating balance arrangement may need to disclose this situation in the footnotes to its financial statements, if the amount is material.

Compensating balances are generally reported on financial statements as restricted cash. Restricted cash is money that is allocated for a set purpose and is thus not available for immediate or general business use. Most businesses experience seasonal fluctuations in the revenues they bring in and the expenses they pay out. They need cash on hand to get them through the dry periods, and they usually get it by obtaining a line of credit, maintaining a savings account, or both. Accounting rules dictate that the bank does not pay interest on compensating balance. However, the customer may still generate interest or revenue from their other account balances that are not subject to the compensating balance requirement.