Overdraft Facilities

Many companies have the need for external finance but not necessarily on a long-term basis. A company might have small cash flow problems from time to time but such problems don't call for the need for a formal long-term loan. Under these circumstances, a company will often go to its bank and arrange an overdraft. Bank overdrafts are given on current accounts and the good point is that the interest payable on them is calculated on a daily basis. So if the company borrows only a small amount, it only pays a little bit of interest. Contrast the effects of an overdraft with the effects of a loan:

Overdraft: Average balance owing for the year �10,000 with an average rate of interest of 10%.

Overdraft interest for the year = �10,000 x 10% = �1,000

Bank loan: Minimum loan available �25,000 repayable after three years with a fixed interest rate of 8%.

Bank loan interest for the year = �25,000 x 8% = �2,000

Interest is payable even if the company didn't actually use the whole �25,000 - we have assumed a minimum amount of loan just for the purposes of demonstration. If the company had to borrow �25,000 but only needed �10,000 on average then it could invest the balance and earn interest in it. The position would now be:

Bank loan interest payable for the year = �25,000 x 8% = �2,000
Interest earned on �15,000 of loan invested at 4% per year = �600
Net interest payable = �2,000 - 600 = �1,400

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