Compensating balances:
A) are used to finance inventories.
B) earn high rates of interest for the firm.
C) are ordered monthly (or quarterly) following forecasts based on cash budget analysis to compensate for shortfalls.
D) increase the effective interest earned by banks on credit lines.
E) require a commitment fee.

Question

Quizplus · Accepted Answer

Compensating balances increase the effective interest rate earned by banks on credit lines because they require the borrower to maintain a minimum balance in a non-interest-bearing account, effectively reducing the amount of credit available for the borrower's use while the bank earns interest on the total loan amount.

Compensating Balances