A bank overdraft is a facility extended by a bank to corporates and other clients to withdraw funds from their accounts in excess of the balance. The bank provides this facility for a fee, and/or interest is charged on the excess amount that is withdrawn for the length of the time.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 a limit on the amount that can be overdrawn from the account. The overdraft limit is usually set by the bank basis on the amount of working capital, the creditworthiness of the borrower, and the security offered by the borrower.
- Advantages of Bank Overdraft
- Disadvantages of Bank Overdraft
Advantages of Bank Overdraft
Handles Timing Mismatch of Flow of Funds
A bank overdraft is usually the best for businesses with greater cash flow movement in a given time frame. An overdraft can help reset a skipped cycle of rotation of inflow and outflow of cash. 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 for managing cash flow gaps that might arise due to timing mismatch.
Helps in Keeping Good Track Record
If a check was made on the basis of some amount to be received, and if it is delayed, the check does not bounce due to inadequacy of funds. Hence, the overdraft facility allows for better payment history.
It also ensures timely payments and avoidance of late payments penalties as payments can be made even if there is a lack of sufficient balance in the account.
It requires less paperwork than would usually be required in long-term loans as an overdraft facility is easy to avail.
Overdraft facility has the advantage of flexibility as one may take it at any time, for any amount (up to the limit allotted), and for even as less as one or two days.
Benefits of Less Interest Cost
The interest is calculated only on the amount of funds used. This allows for greater savings in the interest cost than a normal loan taken for a fixed time period. While in other loans, interest is required to be paid even if the money remains unused. In this case, the charging of interest starts with the amount overdrawn, and it stops instantly when it is paid off.
Disadvantages of Bank Overdraft
Higher Interest Rates
Overdraft facility comes at a cost. At times, the cost is usually higher than the other sources of borrowing.
Risk of Reduction in Limit
An 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. Reduction in the withdrawal of limit may usually happen when company financials represent poor performance; hence, the facility may be withdrawn, especially when the company requires it the most.
Risk of Seizing
Bank overdraft facility may at times be secured against inventory or other collaterals 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, the availability of an overdraft facility may make the company less strict on collecting debtors’ payments. In other words, a company may not be too much on its feet to collect payments from debtors, as an overdraft facility can manage immediate payment outflows.
Overdraft is a temporary facility the companies obtain to meet their ultra-short-term cash shortage/requirement. One must bear in mind that such a facility comes with a high cost and should be used as stop-gap management of funds or as an emergency activity rather than a routine funding activity. Higher dependence on overdraft for working capital financing indicates poor working capital management and a liquidity constraint the company faces. Only temporary working capital should be financed by bank overdraft. The permanent working capital should be financed by long-term financing.
Also, read the Difference between overdraft and cash credit for better clarity.