Restricted Cash

Restricted cash is money that a company owns but is not free to spend on its ordinary operations, because it has been set aside for a specific purpose or pledged under a legal or contractual arrangement. Examples include cash held in escrow for a pending purchase, deposits pledged as collateral for a letter of credit, money a lender requires to be held in a debt service reserve, a bond sinking fund, customer deposits that must be kept separate, and grant funds that may only be spent on approved projects.

Because it cannot be used to pay everyday bills, restricted cash is reported separately from unrestricted cash and cash equivalents on the balance sheet, or explained in the notes. Analysts and lenders pay attention to it because a large cash balance may be less available than it first appears.

Restricted cash is classified according to when the restriction ends or when the cash is expected to be used:

• If the cash will be used to settle a current liability or the restriction lapses within one year or the operating cycle, it is shown within current assets, usually on a separate line.
• If the restriction lasts longer, for example a reserve that must be held until a long-term loan is repaid, it is shown among noncurrent or long-term assets.
• Amounts are disclosed in the notes to the financial statements, together with the nature of the restrictions.

Compensating balances, minimum balances a bank requires a borrower to keep, are a related case. The SEC requires public companies to disclose them, and legally restricted compensating balances are reported separately from cash.

Under US GAAP, ASU 2016-18, effective for public companies from 2018, requires the statement of cash flows to explain the change in the total of cash, cash equivalents and restricted cash. Transfers between unrestricted and restricted accounts are therefore no longer shown as operating, investing or financing flows. Companies must reconcile the total in the cash flow statement to the separate balance sheet lines. Before this change, practice varied, and some companies showed deposits into restricted accounts as investing outflows.

IFRS has no single standard on restricted cash. Under IAS 7, an entity must disclose significant cash balances that are not available for use by the group, such as cash held in a subsidiary subject to exchange controls, and judgment is needed on whether restricted balances still meet the definition of cash equivalents.

A property developer has $12 million in its bank accounts at year end. Of this, $3 million is held in escrow until a land purchase completes in four months, and $2 million is a debt service reserve that must be kept until a loan matures in 2030. Its current liabilities are $14 million and its other quick assets are $6 million.

The balance sheet shows cash and cash equivalents of $7 million, current restricted cash of $3 million and noncurrent restricted cash of $2 million. The cash flow statement reconciles to the $12 million total. For liquidity analysis, a careful analyst excludes the restricted amounts. Using all $12 million, quick assets of $18 million would give a quick ratio of about 1.29. Using only unrestricted cash, quick assets of $13 million give a ratio of about 0.93, a less comfortable picture of the company's liquidity.

Restricted cash can be significant in industries such as construction, real estate, insurance, payments, utilities and project finance, where lenders, regulators or customers require funds to be ring-fenced. Breaching a financial covenant can sometimes trigger further restrictions. When comparing companies, analysts check whether ratios such as the current ratio and net debt have been calculated with or without restricted balances, since including them can flatter a company's apparent cash position.