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A bank overdraft is a temporary facility extended by a bank to corporates and other clients to withdraw funds from their account in excess of the balance. This facility is provided by the bank for a fee and interest is charged on the excess amount that is withdrawn for the length of the time. It is important to know the advantages and disadvantages of the bank overdraft facility in order to use it effectively.
An overdraft facility allows the facility holder to withdraw money from the account despite having no balance. There is usually a limit on the amount that can be overdrawn from the account. The overdraft limit is usually set by the bank basis the amount of working capital and creditworthiness of the facility taker.
Advantages of Bank Overdraft
Handles Timing Mismatch of Flow of Funds
A bank overdraft is usually helpful for a business where it has cash flows moving in and out many times during a month. In other words, if sales proceeds and purchases result in a flow of money in and out many times during a week/month; an overdraft facility allows managing cash flow gaps that might arise due to timing mismatch.
Helps in Keeping Good Track Record
It helps to maintain a good payment history as any payment made via cheque does not bounce due to insufficient funds, which may have been made against some receivable, which may come a couple of days later.
Timely Payments
It also aids in ensuring that timely payments are made and no late payments penalties are faced, as payments would be made even if there is no balance in the account.
Less Paperwork
Overdraft facility is usually easy to avail compared to long-term loans which may require more paperwork.
Flexibility
Overdraft facility is flexible in the nature that one may take it whenever required for whatever amount (up to the limit allotted) and for even as less as one or two days.
The benefit of Interest Cost
Since the interest is calculated only on a number of funds utilized, there are great savings in the interest cost when compared to a normal loan was taken on the fixed interest rate. In other loans, you have to pay interest even if you are not using the money. The meter of interest starts with the payments you make but it stops instantly when there are receipts.
Disadvantages of Bank Overdraft
Higher Interest Rates
Overdraft facility comes at a cost. The cost is usually higher than the other sources of borrowing. Also, if one goes above or exceeds the overdraft limit, the charges thereby are much higher.
The risk of Reduction in Limit
Overdraft facility is a temporary loan and undergoes regular revisit by the bank. Hence, it runs a risk of a decrease in the limit or withdrawal of the limit. The withdrawal of limit may happen usually when company financials may represent poor performance; hence, the facility may be withdrawn largely when the company may require it the most.
Risk of Seizing
Bank overdraft facility may at times be secured against inventory or other collateral like shares, life insurance policies etc. The company may run a risk of those assets being seized if it fails to meet payments.
Debtor’s Collection becomes Lethargic
At times, availability of overdraft facility may make the company less strict on the collection of debtors’ payment. In other words, a company may not be too much on their feet to collect payments from debtors, as immediate payment outflows can be managed by overdraft facility.
Conclusion:
Overdraft is a temporary facility obtained by the companies to meet their ultra-short term cash shortage/requirement. One needs to bear in mind that such facility comes with a high cost and should be used as a stop-gap management of funds or as an emergency activity rather than a routine funding activity. Higher dependence on overdraft for working capital management indicates poor working capital management and a liquidity constraint faced by the company. Only temporary working capital should be financed by bank overdraft. The permanent working capital should be financed by long term loans having lower interest rates.
Difference between overdraft and cash credit.
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