What it means
An overdraft can be arranged in advance or happen without agreement. An arranged overdraft sets a limit that the bank agrees to lend, usually with a published interest rate.
An unarranged one occurs when a payment pushes the account past its limit, and it tends to be far more expensive. For businesses, overdrafts are a flexible way to cover timing gaps between paying suppliers and collecting from customers.
The business borrows only when needed and pays interest only on the amount used. Because the facility can be withdrawn or reviewed by the bank, it is not a reliable source of long-term funding.
Costs can include an interest rate on the daily overdrawn balance, an arrangement fee, a monthly usage fee, and a charge for each payment refused or allowed through. These charges can add up quickly when an account is overdrawn for long periods.
Compare the all-in cost against a term loan or credit card. In accounting, a bank overdraft is generally shown as a liability, usually under current liabilities, and not as negative cash.
Some companies, however, include overdrafts that are repayable on demand in cash and cash equivalents for the cash flow statement. The treatment depends on the accounting standard used.
A nuance is that banks may ask for the overdraft to be cleared on demand. A business that has relied on it for months can find itself short of cash overnight, so regular use is a warning sign.
Interest on an overdraft is normally calculated daily on the balance at the end of each day. This means that clearing the account even a few days early reduces the bill, which is why treasury teams time their large receipts and payments carefully.
In practice
Real-world examples.
Example
A landscaping company pays its seasonal workers on the 28th, but clients settle invoices on the 10th of the following month. It uses a $15,000 overdraft to bridge the gap each spring. The cost is small compared with the revenue it protects.
Example
A freelance photographer accidentally lets a direct debit take her account to minus $300. The bank charges a daily fee until she tops it up. She then moves to an arranged overdraft with a lower cost.
Example
A retailer with a $100,000 overdraft limit finds that it has been using $90,000 of it for six months. The finance manager treats this as a sign that the business needs a proper term loan. He opens talks with the bank.
Formula
Calculation
Overdraft cost = (overdrawn amount x daily interest rate x days overdrawn) + fees
Suppose a business is overdrawn by $20,000 for 30 days at an annual rate of 12%. The daily rate is 12% / 365 = 0.0329%, so interest = 20,000 x 0.12 x 30 / 365 = $197.26. Add a monthly arrangement fee of $25. Total cost for the month = 197.26 + 25 = $222.26. That equals about 1.11% of the amount borrowed for one month.
Reading the result: the $222.26 monthly cost is equivalent to roughly 13.3% a year on the amount borrowed once the fee is included (1.11% x 12). That is higher than the 12% headline rate, so the fee matters. Comparing this all-in rate against a term loan quote shows whether the facility is good value.
A quick rule of thumb is to compare the overdraft rate with the cost of other funding. If a term loan costs 9% a year, then paying 13.3% on a balance that stays overdrawn all year costs about 4.3 percentage points more, which on $20,000 is roughly $860 a year in extra cost.Case study
Seen in the real world.
Tidewater Print is an illustrative, fictional printing company that relied on an overdraft to pay paper suppliers while waiting for large clients to settle. The overdraft limit was $50,000 and was used steadily throughout the year.
When the bank reviewed the facility, it reduced the limit to $30,000 with only a week's notice. The company could not meet its next payroll and had to ask a client for early payment.
The owner then arranged a $60,000 term loan and kept a smaller overdraft for short gaps. The illustrative lesson is that an overdraft suits temporary swings, and ongoing funding needs should be financed in a more stable way.
Watch out
Common mistakes.
- Treating an overdraft as extra cash that belongs to the business, when it is borrowed money that must be repaid.
- Ignoring unarranged overdraft charges, which are usually much higher than the arranged rate.
- Relying on a permanent overdraft for long-term funding, when the bank may reduce or withdraw it.
Questions
People also ask.
Is an overdraft a loan?
Yes, in effect it is a flexible loan from the bank that you repay when money is paid in.
Does an overdraft affect credit scores?
It can, because lenders see regular or heavy use and unarranged overdrafts as a sign of financial strain.
Where does an overdraft appear in accounts?
Normally as a current liability, though some standards allow it within cash and cash equivalents when it is repayable on demand.
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