In accounting, "cash" refers to the money held by a company in liquid form that can be spent or invested. Restricted cash is money that is reserved for a specific purpose and therefore not available for immediate or general business use.
Examples of restricted cash
There are many scenarios in which a company might need to set aside a specific amount of restricted cash. Common examples of restricted cash include refundable deposits, minimum balances on bank accounts, and funds held in escrow. Our broker center has plenty of information to get you more familiar with the stock market!
It is often the case that restricted cash results from a legally binding agreement. For example, if a company receives a bank loan, the lending institution's contract might stipulate that the company reserve a certain amount of money in a restricted cash account that will remain unavailable for spending for a preset period of time.
However, not all restricted cash arises from legal or contractual obligations. Sometimes a company will voluntarily decide to set aside restricted cash. For example, a company might choose to reserve a certain amount of money for a new project and designate that cash as restricted.
Reporting restricted cash on financial statements
A company's balance sheet must include all assets and liabilities, including cash. Restricted cash is reported separately from cash and cash equivalents on a company's balance sheet, and the reason the cash is restricted is typically revealed in the financial statement's accompanying notes.
Restricted cash may be classified as a current or non-current asset depending on how long it's expected to remain restricted. If the cash in question is expected to be used within one year of the balance sheet date, the cash should be classified as a current asset. However, if it is anticipated that the cash will remain unavailable for use for more than a year, then it should be classified as a non-current asset.
Compensating balances
A compensating balance is a minimum balance that a company must maintain in an account as part of an agreement with a current or potential lender. A compensating balance is typically used to offset a portion of a bank's costs when lending out money and is generally calculated as a percentage of the loan. For example, a company might agree to keep $500,000 in a bank account in exchange for that bank extending a $5 million line of credit. Compensating balances are considered restricted cash and must be reported on a company's financial statement.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com. Thanks -- and Fool on!
