When a current account holder permitted by the banker to draw more than what stands to his credit, such an advance is called an overdraft. The banker may take some collateral security or may grant such advance on the personal security of the borrower. The customer is permitted to withdraw the amount as and when he needs it and to repay it by means of deposit in his account as and when it is feasible for him. Interest is charged on the exact amount overdrawn by the customer and for the period of its actual utilization.
Generally an overdraft facility is given by a bank on the basis of a written application and a promissory note signed by the customer. In such cases an express contract comes into existence. In some cases, in the absence of an express contract to grant overdraft, such an agreement can be inferred from the course of business.
Cash withdrawals from a bank account already overdrawn will automatically increase the size of the overdraft. An overdraft facility does not have a repayment timetable like most term loans; therefore a business that uses an overdraft facility pays interest only for the period the bank balance is overdrawn or is in negative territory. Interest on a bank overdraft is highly volatile and is paid or accrued daily. Bank overdrafts are acquired to cover temporary short term shortage of cash resources. A bank overdraft may be acquired for example; to finance on going working capital requirements or to support a start up business when it is still trying to find its feet. Advantages of an Overdraft
An overdraft facility is a very useful form of funding particularly to small to medium businesses and to business start ups because these usually struggle for cash. In most cases these businesses have expense commitments which cannot all be settled by cash inflows from their sales income, therefore they need an overdraft facility to finance the deficit. ❖ A bank overdraft facility is quick and cheap to arrange as the borrower does not need to undergo the stringent scrutiny subjected to borrowers of long term loans. ❖ The company only pays interest on a bank overdraft facility only when it has a debit balance on its bank account. If the balance is in positive territory there will be no interest charge. ❖ An overdraft is flexible as the borrower only borrows what they need to use at the time and this makes it cheaper than loans. ❖ There are no penalties or charges for paying off the overdraft earlier as the borrower can repay the overdraft at any time. Disadvantages of an Overdraft
❖ A bank overdraft is usually a privilege offered to customers for banking with a certain bank. Unlike a term loan the borrower will enjoy access to an overdraft facility from a bank only if the company continues to maintain a current account with the bank. ❖ A bank overdraft has to be rearranged regularly usually annually and normally arrangement fees are charged by the lender to the borrower. This constant need for reviewing and renegotiating of a bank overdraft facility poses as a risk to the availability of working capital support to a business if the bank decides not to renew it. ❖ The interest rate applied on an overdraft facility is usually at a variable rate and this makes it difficult for a company to manage its borrowing costs and interest rate risk. ❖ Bank overdrafts are repayable on demand and the lender may call them anytime. This unplanned overdraft facility withdrawal or recall may put pressure on the cash needs or day to day financing of the business. Penalties or administration fees are also charged by the lender if the credit limit is exceeded. ❖ Overdrafts are usually secured against business assets and the lender can take control of the business' assets if it defaults on its overdraft repayment. Reasons for overdrafts
Overdrafts occur for a variety of reasons. These may include: • Intentional short-term loan: The account holder finds themselves...
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