External sources of finance come from outside the business. Overdraft belongs to external sources of finance. When businesses need to use the money for a short period of time (less than one year), this creates the need for short-term finance.
2. Overdraft
Overdraft is when the bank agrees to let the business spend more money than the business has in its official bank account. The business is allowed to overdraw its corporate bank account up to an agreed limited.
How does overdraft work?
Overdraft is provided to most of the corporate customers by the bank in the form of extended credit line which comes into effect once the main balance of the account reaches zero. This allows the business to temporarily take out more money than it has in its account.
Who can get overdraft?
Overdrafts apply to both small private limited companies and very large public limited companies.
Most businesses nowadays will have some sort of an overdraft agreement with their banks, such as Bank of America. This allows businesses to withdraw a certain sum of money from their corporate bank accounts which is greater than the available balance.
Why businesses need overdrafts?
Overdrafts are commonly used in case of cash flow problems:
- Too much trade credit. For businesses that sell products on credit to their customers and are awaiting payments.
- Sudden spike in demand. For businesses that have sudden needs for a large cash outflow such as stocking up inventories for trading periods with high demand.
When does overdraft need to be repaid?
In each individual case, the bank will decide how soon the overdraft has to be repaid by the company. In general, the overdraft has to be repaid within 12 months as it belongs to Short-Term Liabilities on the Balance Sheet.
Advantages of overdrafts
- Easier to apply and get approved than a typical bank loan. Overdrafts save time and paper both to the business and the bank. Compared to standard short-term and long-term bank loans, an overdraft is relatively easy to handle anytime. It also requires minimal paperwork from both parties.
- Cost effective. Although overdrafts can demand a relatively high interest rate, they are usually more cost-effective than bank loans. This is because, unlike typical bank loans, overdrafts are used as short-term sources of finance. Interest is charged on a daily basis only after the business overdraws on its account.
- Flexible. A bank overdraft is the most flexible source of finance. This means that the amount raised can vary from day to day, depending on the particular business needs. Also, businesses are able to change the amount of borrowing at short notice.
Disadvantages of overdrafts
- The overdraft amount must be agreed in advance. This overdrawn amount must be agreed the bank, and the business is not allowed to go beyond that limit. Sometimes, businesses may need to increase the overdraft for short periods of time, if customers do not pay as quickly as expected, or if a large delivery of raw materials has to be paid for.
- More expensive than the bank loan. Overdrafts come with high interest rates, much higher than that of a regular bank loan. This makes overdrafts relatively pricey, if the company goes over the agreed overdraft amount. The cost of this type of borrowing is often higher than most other sources of borrowing. For this reason, overdrafts are usually only used to meet unexpected short-term cash shortages.Â
- Can be recalled by the bank. The ability to draw an overdraft can be recalled anytime. The bank can cancel the overdraft, if the business fails to meet the terms and conditions, let alone failing to repay back the money.Â
- Overdrafts are repayable on demand. If a bank becomes concerned about the stability of the business, it can force the firm to pay it back. This, in extreme cases, can lead to business failure due to insolvency.
- Collateral is required. An overdraft is attached to business assets and the bank can take property or other Fixed Assets in the event of the business organization failing to make repayments.
In summary, an overdraft provides flexibility for businesses that might occasionally face unexpected cash flow problems.
The bank allows the business to ‘overdraw’ on its account by making payments, transferring money or writing cheques to a greater value than the balance in the account. This form of finance often carries high daily interest charges.
