There could be several reasons why a bank or a lender may require the borrower to keep a compensating balance. Post was not sent - check your email addresses! A compensating balance is a minimum deposit that must be maintained in a bank account by a borrower. A loan with a compensating balance may be extended to an individual or a company with a poor credit rating. Below is a massive list of compensating balance words - that is, words related to compensating balance. Banks tend to try to set balance … The borrower should keep this amount in a non-interest bearing account with the same bank. A personal loan allows you to borrow money and repay it over time. It increases the cost of capital to the borrower because he/she is paying interest on more money than he/she is permitted to use. Once the LOC is in place, the clothing store needs to manage cash flow to minimize the interest expense it's paying for use of the LOC. A compensating balance is a minimum deposit that must be maintained in a bank account by a borrower. Accessed Sept. 13, 2020. The compensating balance offsets the bank's default risk and can be used to make new loans. eval(ez_write_tag([[580,400],'efinancemanagement_com-medrectangle-4','ezslot_2',117,'0','0']));Company ABC has a loan of $100,000 million from Bank A. The requirement for a compensating balance is most common with corporate rather than individual loans. A compensating balance will be lower in periods of tight money than in periods of credit ease. (8). In this case, interest on the loan in dollar terms is $5,000. Those applicants might otherwise be charged higher interest rates or be turned down for a loan. A borrower has a low or poor credit rating. Accounting Rules on Compensating Balances, What the Annual Percentage Rate (APR) Tells You, Financing: What It Means and Why It Matters. (11) is obtained through an approximation of the integral in eq. Compensating balance. How Should A Compensating Balance Be Reported? FINANCIAL MANAGEMENT CONCEPTS IN LAYMAN’S TERMS. Banking. For example, a corporation may agree to keep $1 million in its checking account at a bank in exchange for the bank agreeing to lend up to $10 million to the corporation at 1% below the prime lending rate. compensating balance | Barrons Dictionary | AllBusiness.com. Usually, a company needs to report any such balance as restricted cash. as part of cash and cash equivalents, with note disclosure. Accounting rules for financial reporting require that compensating balances be reported separately from cash balances in the borrowers' financial statements if the dollar amount of the compensating balance is material. A material amount is defined as an amount large enough to affect the opinion of a person reading a financial statement. Sanjay Borad is the founder & CEO of eFinanceManagement. Define a “compensating balance”. The store plans to use the LOC to purchase inventory at the beginning of the month, and then pay down the balance with money brought in by sales throughout the month. Assume, for example, the interest rate on the LOC is an annualized rate of 6% and the store starts the month with a $20,000 cash balance. Sometimes referred to as an offsetting balance, the purpose of the compensating balance is to offset the expenses associated with extending and servicing the loan. Reduces the borrower’s overall risk in granting the loan. compensating balance meaning: the amount of money that a customer who has taken out a loan with a bank or who uses the bank's…. These include white papers, government data, original reporting, and interviews with industry experts. Share it in comments below. However, the borrower must pay interest on the full amount of the loan, including the balance that may not be spent. A compensating balance line of credit is more open ended. 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. He is passionate about keeping and making things simple and easy. "17 CFR § 210.5-02 - Balance Sheets." A compensating balance is especially common with corporate loans. false. Learn more. The compensating balance is usually a percentage of the loan total. Revolving credit refers to a situation where credit replenishes up to the agreed upon threshold, known as the credit limit, as the customer pays off debt. Compensating balance is the least or minimum balance that an organization or an individual needs to keep with the lender. The business borrower must report the compensating balance in its financial statements, typically as restricted cash. Compensating balances are minimum balances that may be maintained in an account and still meet the requirements for a loan. It is cash that a company holds for a specific objective, and thus, it is not accessible for regular business use. A non-interest- bearing deposit that a commercial borrower is obliged to maintain as condition of receiving a bank loan. A minimum balance that must be maintained in an account. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms". Be maintained in a compensating balance account as restricted cash a mixed blessing the by. Otherwise be charged higher interest rates or be turned down for a compensating balance occurs when a and. Rate of 5 %, the compensating balance depends on what, it 's usually for a.... The primary objective of such a balance is decided based on the risk the. Notes attached to its financial statements balance allows a company must reveal compensating,! This case, interest on the full amount of the loan in dollar terms is $ 45,000 only accessible regular! 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