Why a bank overdraft is not necessarily a bad thing
The bank overdraft is a form of short-term credit that account holders can take advantage of without entering into a credit agreement by overdrawing their current account. Here we show you how a bank overdraft works, what advantages and disadvantages it has and how it is treated in the balance sheet.
A bank overdraft makes it possible to overdraw a current account. This means that if an outgoing payment is higher than the money still available in the account, the payment can still be made thanks to the bank overdraft, even if the account does not have sufficient funds. The bank overdraft is therefore a form of credit.
The amount of the bank overdraft is determined by the bank or the lender. The creditworthiness of the account holder plays a major role: the better the creditworthiness, the higher the bank overdraft, as well as more favourable interest terms and payment conditions the bank can grant.
A company's current account has a maximum bank overdraft of £500. If there is £1,500 left in the account and a payment of £2,000 is made, the account will then be £500 in the negative. If a payment is received on the current account, the account is balanced again.
If the bank overdraft limit was £300, the payment would not be made as the account cannot be overdrawn beyond this limit.
The fees for a bank overdraft are very high compared to other loan interest rates. They vary greatly depending on the bank, the amount of the overdraft limit and the creditworthiness of the customer.
A distinction must also be made between an authorised and an unauthorised bank overdraft. For the latter, interest payments are usually even higher than for an authorised overdraft.
A bank overdraft in the balance sheet or trial balance is shown as credit. Because of the interest rate that has to be paid back to the bank within at least 12 months, it is considered a short-term loan.
Usually, a bank overdraft is covered with the next incoming payment, so that the loan doesn't exist anymore after that. However, if the overdraft still exists at the end of the company's reporting period, it needs to be reported as a short-term liability in the balance sheet.
Whether the bank overdraft is an asset or a liability always depends on the perspective: for the bank granting the bank overdraft, it is an asset; for the company using the bank overdraft, it is a liability.
One advantage of the bank overdraft is that it can be used to pay short-term liabilities even if there is not enough money in the account at the time of maturity. This prevents the payment from not being executed and thus falling into arrears.
For example, if a company has an invoice of £5,000 to pay but only £4,000 in the account, bank overdraft can be used to pay the invoice on time. When the next payment is received in the account, the shortfall is made up. This way, the company does not have to ask the creditor for an extension or look for cash elsewhere.
The bank overdraft is particularly suitable when a short-term liability unexpectedly arises for a company (e.g. the invoice for the repair of a production plant). It also prevents payments from not being executed (e.g. the collection of direct debits), so that the company does not have to deal with the additional effort of separate transfers.
If a company needs a short-term loan of a small amount, the bank overdraft is the most uncomplicated option, as it is not necessary to submit a separate loan application to the bank.
The biggest disadvantage of the bank overdraft is that it is very expensive, as banks pay very well for providing this short-term credit. The longer an account is unbalanced - that is, in negative territory - the higher the interest payments. Therefore, one should not wait too long before balancing the account.
Another disadvantage is that the limit can be adjusted downwards by the bank at will - depending on how often the bank overdraft is used and how well the account holder is able to balance the account again afterwards. In return for providing a bank overdraft, banks sometimes require the deposit of collateral. For example, a company must be liable with part of its assets if it cannot settle an overdrawn account.