Restricted Cash

Cash set aside for a specific purpose, making it unavailable to the company for immediate or general corporate use.

The term "restricted cash" refers to cash set aside for a specific purpose, making it unavailable to the company for immediate or general corporate use.

Conversely, unrestricted cash is readily available for general business use on an immediate basis.

The cash is held in a special account and therefore remains separate from the rest of the business's cash and cash equivalents

Since it is not considered a part of the liquidity source, it is excluded when calculating various liquidity ratios. Therefore, it appears as a separate entity from the cash and cash equivalents on the company's balance sheet.

Restricted cash can be classified as either a current or non-current asset, depending on the period of restriction. 

  • When the cash is expected to be used within the current accounting year, it falls under the current asset.
  • However, if the cash is anticipated to remain unavailable for more than a year, it is classified as a non-current asset. 

Uses of restricted cash: why do companies have it?

The restriction may exist for a specific period or until a certain event occurs. These limitations might apply to money saved in escrow accounts, which can only be used for a specific function.

Uses

1. Loan payments

A company receiving a bank loan may be required to maintain a certain amount of cash as restricted cash. This is done to ensure partial security for a certain time. 

The company then holds this money under a new account, where it maintains the percentage of the loan (specified by the bank) as restricted cash.

2. To ensure services are met 

Customers who deal with services delivered only after full payment may request through a contract that the firm not utilize the funds until the service is delivered.

3. As collaterals

An insurance provider may demand that a business put up a specific sum of money as risk-reduction collateral.

4. Debt payments and Capital expenditure

A company is not always legally obligated to restrict cash. Sometimes a firm may reserve a specific sum of money to pay off long-term debt or start a new project such as setting up a new plant or buying equipment. 

Capital expenditure = Current assets - Current liabilities

The capital expenditure is calculated as the difference between the current assets and the current liabilities.

Examples

1. Let us say company X is a large rubber manufacturer. The bank requests that the company open a limited cash account (which can be a separate account) and maintain a balance of $18,000, or 8% of the entire amount borrowed, to draw a $300,000 line of credit.

This minimum reserve must be maintained throughout the stipulated period. So restricted cash is legally binding in this case.

2. Now say the same manufacturing company receives an order and is paid half by the customer. 

The customer may state in their contract that the manufacturer deposits this amount to a separate account and does not use it until the order is fulfilled. The company then accounts for this payment as restricted cash. 

3. Lien on fixed deposit for the purpose of the loan.

4. A security deposit is a fixed deposit or cash given to the government or any other private enterprise.

Financing restricted cash: How do you present it?

  • It appears as a separate item from the cash and cash equivalents on the company's balance sheet. 
  • It is then classified as a current or non-current asset depending on its period of restriction.
  • The amount of cash that accounts for the restricted money is added on the right-hand side of the balance sheet (the balance column). 
  • The reason for the cash being restricted is revealed in the accompanying financial statement notesP&G balance sheet

Source: Wikipedia

The total must reconcile to the same amounts on the statement of assets and liabilities.

Consequently, direct third-party cash receipts and restricted cash payments are categorized as cash flows from operating, investing, or financing activities.

However, the transfers between unrestricted and restricted cash and equivalents are not presented as cash flows from operating, investing, or financing activities.

The purchase price is obtained by deducting the company's net debt from the enterprise value (EV) at the date of closing. While calculating the net debt, the cash and bank balances shall always consider unrestricted cash (free cash).

1. Under IFRS (International Financial Reporting Standards)

There is no definition of "restricted cash" in the IFRS Standards, and it is unclear whether restricted sums should be included in the beginning or ending balances of a company's cash and cash equivalents in the statement of cash flows.

However, among other requirements, the quantities must either be held in hand, quickly convertible into known amounts of cash, or accessible for withdrawal at any time without penalty to fit the definition of cash and cash equivalents. 

The primary need for "cash equivalents" is that they are held for short-term cash needs rather than long-term planning or other uses. 

IAS 7 mandates disclosure of the quantity and a description of the restriction in cases where considerable amounts are not readily usable by the group.

2. Under GAAP (Generally Accepted Accounting Principles)

According to US GAAP, restricted funds are included in total cash and cash equivalents in the statement of cash flows even if they are shown separately from cash and cash equivalents on the balance sheet. The company then compares the two totals for cash and cash equivalents.

Excluding restricted cash from liquidity ratios

An accounting ratio, also known as a finance ratio, is the relative magnitude between two numbers obtained from an organization's financial accounts.

Liquidity ratios are a measure of the ability of a company to pay off its short-term liabilities.

Types of liquidity ratios:

  1. Current Ratio or Working Capital Ratio
  2. Cash Ratio is also known as Cash Asset Ratio or Absolute Liquidity Ratio
  3. Net Working Capital Ratio
  4. Quick Ratio is also known as Acid Test Ratio

Since the cash restriction is rendered out of the company's cash flow, it's excluded from multiple liquidity ratios, such as the quick and cash ratios. 

Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + accounts receivable) / Current Liabilities

A quick ratio indicates a company's short-term ability to use its cash or quick assets, thereby determining its short-term financial position. The higher the ratio, the easier the ability to pay off debts. 

If a finance analyst makes the mistake of adding the company's restricted cash to cash and equivalents while calculating the quick ratio, they excessively account for the company's liquidity. 

Remember it is also not included while calculating enterprise value.

Restricted fund

A reserve account that holds money that can only be utilized for particular purposes is known as a restricted fund. They are most frequently seen in relation to money owned by specific nonprofit organizations, academic institutions, or insurance firms.

A donor may legally instruct that the donations be used for a specific purpose. Therefore a nonprofit organization keeps the fund aside as a restricted fund. 

A donor may specify the fund usage as:

  • Temporarily restricted funds- A temporarily restricted fund can typically only be used for a specific purpose within a certain timeframe. 
  • Permanently Restricted Fund- Only the interest is permitted to be spent; the donation is intended to be retained in eternity as principal on which interest may be generated.

Foundations offering donations specify how they want their fund to be distributed and used.  

To properly manage the funds they have to spend; nonprofit organizations should divide restricted and unrestricted funds when creating their budgets.

An organization doesn't need to put the money in a separate bank account. Instead, it could specify the accounting on their financial statement.

Special case of Compensating balance

A compensating balance is a minimum deposit a borrower must maintain in a bank account. 

The purpose of this balance is to reduce the lending cost for the lender since the lender can further give this money as a loan. Compensating balances are mostly reported on financial statements as restricted cash. 

Small startups generally don't have a credit history and are forced to accept the compensating balance as a borrower.

It can be calculated in two ways: as an average balance arrangement common with installment loans or a minimum fixed balance arrangement used with lines of credit.

The example of a rubber manufacturer company is a case of compensating balance where company X needs to maintain a minimum balance which is generally a percentage of the total loan.

Key Takeaways
  • Cash set aside for a specific purpose, making it unavailable to the company for immediate or general corporate use, is called restricted cash.
  • It can be used for debt payment, capital expenditure, loan payment, or collateral.
  • It is classified under current or non-current assets.
  • It appears as a separate item from the cash and cash equivalents on the company's balance sheet. 
  • It is excluded from the quick ratio and cash ratio. 
  • A reserve account that holds money that can only be utilized for particular purposes is known as a restricted fund.
  • A compensating balance is a minimum deposit that a borrower must maintain in a bank account. 
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Researched and authored by Ishpreet Kaur | LinkedIn

Reviewed and Edited by Abhijeet Avhale | LinkedIn

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