Lecture Notes: Overdrafts as a Source of Finance

Definition and Purpose

• Overdrafts occur when a business withdraws more cash than it has in its bank account, resulting in a negative balance.
• Purpose of Overdrafts:
  • Ease working capital concerns (current assets - current liabilities).
  • Manage short-term obligations to creditors.
  • Handle unexpected expenditures.
  • Commonly used by startups and new businesses due to lack of cash inflow.
  • Also applicable for SMEs but primarily beneficial for startups lacking positive cash flow.

Characteristics of Overdrafts

• Type: Short-term external source of finance (from a bank).
• Popularity: Frequently used by new/startup businesses.

Advantages of Overdrafts

1. Quick and Easy Setup:
   • Simple to organize with a financial intermediary (bank).
   • Immediate availability once agreed.
2. Customizable:
   • Can be tailored to business needs, useful for seasonal businesses.
3. No Loss of Control:
   • No equity or shares are given up.
   • Does not affect business ownership.
4. Short-term Debt:
   • Not included in the gearing ratio (focuses on long-term debt).

Disadvantages of Overdrafts

1. Higher Interest Rates:
   • Higher than loans due to increased risk for banks (no fixed repayment schedule).
   • Designed as a short-term financing solution.
2. Potential Cancellation:
   • Banks can theoretically cancel overdrafts, typically only if there are persistent financial issues.
3. Impact on Credit Rating:
   • Persistent use can damage credit rating.
   • Might lead to higher interest rates on future loans or outright rejection.

Summary

• Overdrafts are a practical short-term solution for managing cash flow issues.
• While they offer flexibility and ease of setup, they come with higher costs and potential risks to credit ratings.
• Important for businesses to use overdrafts judiciously to maintain financial health.