What it means
Banks price loans on total relationship profitability, not just the interest rate. A compensating balance is one way of getting paid: the deposit costs the bank nothing or almost nothing and can be lent out, so the bank can quote a lower rate and still earn the same margin.
For the borrower the arrangement is a trade. You accept a stated rate that looks attractive, but you also accept that a slice of the facility is unusable, and the interest you pay is spread over a smaller pool of money you can actually deploy.
Working out whether the deal is good means comparing the effective rate with what an unrestricted loan would cost. If the required balance is money the business would have kept at that bank anyway for payroll and payables, the real cost of the arrangement is small, and if it is money you would otherwise have invested or spent, the cost is substantial.
Compensating balances also show up as a disclosure issue. Restricted cash of this kind is not freely available, and accounting standards generally require it to be disclosed and sometimes classified separately from ordinary cash, which changes how a reader assesses liquidity.
The common variants are worth watching. Some agreements require an average balance over a month or quarter rather than a minimum at all times, which is far easier to manage, and others allow the balance to be replaced by a fee, in which case the fee should be compared with the interest cost of the tied-up cash.
In practice
Real-world examples.
Example
A regional manufacturer negotiates a $2,000,000 revolving line at 6.5% with a 10% compensating balance. Because it already keeps around $200,000 on deposit for payroll, the treasurer calculates that the arrangement costs almost nothing extra and accepts it.
Example
A fast-growing e-commerce retailer is offered the same structure but runs on very thin cash balances and sweeps everything into inventory. The tied-up $150,000 would otherwise have bought stock turning four times a year, so the company negotiates a higher rate with no balance requirement instead.
Example
A property developer's auditor identifies $400,000 of compensating balances required under two construction loans. The amount is reclassified out of cash and cash equivalents and disclosed as restricted, which reduces the reported current ratio and prompts a question from the audit committee.
Formula
Calculation
Effective interest rate = interest paid / usable loan proceeds, where usable proceeds = loan amount - required compensating balance.
A distributor borrows $500,000 at a stated rate of 8% and agrees to keep a compensating balance of 20% of the facility in a non-interest-bearing account.
Interest paid = $500,000 x 8% = $40,000.
Required balance = $500,000 x 20% = $100,000.
Usable proceeds = $500,000 - $100,000 = $400,000.
Effective rate = $40,000 / $400,000 = 10%.
The 8% loan is really a 10% loan. If the business would in any case have kept $60,000 of operating cash at that bank, only $40,000 is genuinely tied up, usable proceeds become $460,000 and the effective rate falls to $40,000 / $460,000, or about 8.7%.Case study
Seen in the real world.
Marlowe Precision Tools is an illustrative, fictional engineering business that took a $2,000,000 working capital facility with a 15% compensating balance requirement at a stated rate of 7%. The managing director was pleased with the rate, which was a full point below the next best quote.
The finance manager worked through the arithmetic. Interest was $2,000,000 x 7% = $140,000, the required balance was $2,000,000 x 15% = $300,000, usable proceeds were $1,700,000, and the effective rate was $140,000 / $1,700,000, or about 8.2%. The competing offer at 8% with no balance requirement was therefore the cheaper deal.
The fictional company went back to the first bank, which agreed to count an average quarterly balance rather than a permanent minimum. Because the business held between $250,000 and $500,000 of operating cash through most of the quarter anyway, the requirement became largely costless, and the arrangement moved from being slightly worse than the alternative to being clearly better.
Watch out
Common mistakes.
- Comparing loan offers on the stated interest rate alone. A compensating balance requirement can turn a headline 8% loan into a 10% loan, and only the effective rate makes offers comparable.
- Counting compensating balances as available cash in a cash flow forecast. The money cannot be spent without breaching the agreement, so treating it as liquidity overstates the funds actually on hand.
- Ignoring the difference between a minimum balance and an average balance. An average requirement can often be met with cash the business already holds at some point in the cycle, while a permanent minimum ties up the money completely.
Questions
People also ask.
Are compensating balances still common?
They are less common than they once were, particularly for larger corporate borrowers, but they still appear in middle-market lending, construction finance and relationship-priced facilities.
How are they treated in the accounts?
Legally restricted balances are generally disclosed and, where the restriction is significant, reported separately from unrestricted cash so that readers can assess real liquidity.
Can you negotiate them away?
Frequently yes, either by accepting a higher stated rate, by paying an explicit facility fee, or by converting a minimum requirement into an average balance test.
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