Overdraft

What it means

An overdraft is a permitted negative balance on a current account up to an agreed limit. The company draws only what it needs and pays interest on the amount actually used, for the days the account is in the red.

It differs from a term loan in having no repayment schedule. It repays itself when money arrives and can be drawn again - which is why it is meant for operations, not for investment.

In the books, a negative current account balance is not shown as minus cash but as a short-term bank loan. A company can therefore show money in one account and a debt to the bank on another in the same balance sheet, which looks odd at first sight but reflects reality. The two are not netted against each other.

How it works in practice

The typical use is bridging the gap between paying a supplier and being paid by a customer, i.e. funding working capital. Factoring solves the same problem but attaches to specific invoices.

The bank looks at account turnover, cash flow and the history of the relationship; the limit is usually reviewed annually. Interest and fees are financial costs of the period in which they arise.

A construction firm that pays for materials and subcontractors months before the first payment from the developer draws on its overdraft in summer and clears it in autumn. When planning we account not only for interest on the amount drawn but also for the commitment fee on the unused limit that banks often charge, and for the lien or shareholder guarantee a bank may require against the limit.

What to watch out for

A permanently drawn overdraft is not working capital finance but hidden long-term debt - and the bank sees it that way at renewal. If the account never returns to credit, the problem is not payment terms but liquidity or margin.

An overdraft is usually agreed for a fixed term, and at renewal the bank may cut it or not renew it at all, especially if the accounts have worsened or the company has broken its covenants. A company that uses it to cover routine payments can then lose its payroll money overnight. So it is worth having a fallback ready, such as factoring or a term loan.