Compensating balances to ensure that the borrower

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Unformatted text preview: changes and the firm makes them anyway, the bank has the right to revoke the line of credit. Compensating Balances To ensure that the borrower will be a good customer, many short-term unsecured bank loans—single-payment notes and lines of credit—require the borrower to maintain, in a checking account, a compensating balance equal to a certain percentage of the amount borrowed. Compensating balances of 10 to 20 percent are frequently required. A compensating balance not only forces the borrower to be a good customer of the bank but may also raise the interest cost to the borrower. Estrada Graphics, a graphic design firm, has borrowed $1 million under a line-ofcredit agreement. It must pay a stated interest rate of 10% and maintain, in its checking account, a compensating balance equal to 20% of the amount borrowed, or $200,000. Thus it actually receives the use of only $800,000. To use that amount for a year, the firm pays interest of $100,000 (0.10 $1,000,000). The effective annual rate on the funds is therefore 12.5% ($100,000 $800,000), 2.5% more than the stated rate of 10%. If the firm normally maintains a balance of $200,000 or more in its checking account, the effective annual rate equals the stated annual rate of 10% because none of the $1 million borrowed is needed to satisfy the compensating-balance requirement. If the firm normally maintains a $100,000 balance in its checking account, only an additional $100,000 will have to be tied up, leaving it with $900,000 of usable funds. The effective annual rate in this case would be 11.1% ($100,000 $900,000). Thus a compensating balance raises the cost of borrowing only if it is larger than the firm’s normal cash balance. Annual Cleanups To ensure that money lent under a line-of-credit agreement is actually being used to finance seasonal needs, many banks require an annual cleanup. This means that the borrower must have a loan balance of zero—that is, owe the bank nothing—for a certain number of days during the year. Insisting that the borrower car...
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This document was uploaded on 01/19/2014.

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