Let's have a sesh on sources of finance and this time we're going to look at overdrafts. So overdrafts definition is when a business withdraws more cash from a bank account than it holds. So essentially it means your bank account has gone below zero. It's gone negative.
Why you might want an overdraft or number one is you might want to ease your working capital concerns. Remember, working capital is your current assets minus your current liabilities. Current assets, short-term things you own, minus current liabilities, short-term things you owe. A likely short-term thing you owe will be your creditors.
You owe your suppliers. And if they come knocking at your door asking for their cash back, well... That will be eased, so your working capital concerns will be eased if you have access to an overdraft, because you might be able to pay them off even though you don't have the current assets, the short-term assets being cash, debtors or stock, because stock and debtors you can't pay with, so if you don't have the cash, then you'll need the overdraft. Also, an overdraft will be useful because... you might have unexpected expenditures that occur and it's a way of coming up against them and being able to pay for them so overdrafts short-term form of finance it's an external source of finance because you got it from a bank which is not part of your business it's come from outside your business and it's used commonly by new or startup businesses essentially because they haven't generated enough cash inflows enough profit in order to be able to sustain themselves.
So often used by new or startup businesses. However, it can be used by SMEs, small or medium enterprise. Of course it can, but it's often used by new and startup businesses because they don't have the cash flow, that positive cash flow to keep them going. Okay, pros, cons of overdrafts. Number one, so it's quick and simple to organize an overdraft.
you essentially go to your financial intermediary aka your bank and then you can sort it out and once you've agreed it you're you're going to have immediate availability once it's agreed so it's going to be there you can dip below your zero you can dip below more cash than your bank account holds and also it can be bespoke it can be tailored it can be custom made to your business and potentially your business is a seasonal business like an ice cream van and in ice cream van land you don't sell many ice creams in the winter. You sell a lot in the summer. So you might have fluctuating cash flow. And if you have fluctuating cash flow in that cold winter December, you might want to have that overdraft facility.
So number three, so no control of the business is given up. Well, it's not any form of equity. There's no shares given up.
So that's great. And a fourth point, if you're doing A-level, very useful to know is that Short-term debt. This is a short-term debt. So therefore it is not involved in your gearing ratio when you're looking at how much debt your business is made up of.
Because when you talk about debt for gearing, you're talking about long-term debt. Okay, let's talk about the cons. So the cons is number one, well, you usually pay a higher interest rate on an overdraft versus a loan.
The reason why is because loans you Basically, you agree when you're going to pay it back at the start, so there's less risk in that form, because you've agreed the repayments every month you're going to make. With overdrafts, the bank doesn't actually know exactly when they're going to get their money back, so therefore you're more risk, and therefore they charge a higher interest rate. Higher interest rates coming from overdrafts means that overdrafts are a short-term finance. Number two, so the bank... could cancel your overdraft at any time that is theoretically possible that the bank could go you're not going to have an overdraft anymore but let's be real it's only likely to happen if you've had persistent financial problems and the bank is essentially worried it won't get its cash back so it will remove its overdraft so it's possible but unlikely only going to happen in that scenario and number three is if you persistently use your overdraft well it might ruin your credit rating and if you ruin your credit rating it might mean two things one is in the future if you apply for a bank loan for example you might be paying a higher interest rate than you otherwise would want to and that means more costs effectively and number two is if you've got a really poor credit rating from persistent use of overdrafts it's actually possible a bank might reject you from a bank loan in the future, particularly if you're looking to expand your business in the future.
So I hope that helps with overdrafts and I'll see you at the next sesh.