Bank overdraft: Meaning, Advantages and Disadvantages

Bank overdraft

This is the permission granted by the bank to its customers to write cheques even though customers have insufficient funds in their accounts. Normally a bank puts a limit for the facility, but so long as the limit has not been exhausted the customer has a right to use the facility.

Advantages

1. It can be raised very fast and can therefore be used to build the company out of short term liquidity problems.
2. It is usually not secured.
3. It is provided without conditions
4. It doesn’t involve any floatation costs.
5. Its costs and financial constraints are short lived.
6. It does not increase the firms gearing.
7. It can be applied without the consent of shareholders. It can therefore be used to meet the company’s immediate financial needs.

Disadvantages

1. It is very expensive. Interest on overdraft is higher than interest on long term loan.
2. Its constant use is a sign of poor financial management.
3. It is not accessible to all firms.
4. It can only be raised by financially sound firms which are well known to the lender.
5. It is open to misuse because it can be used without shareholders consent.
6. It is available in small quantities and cannot therefore be invested in long term project which are more profitable.
7. It can be recalled at any time or on short notices. This may leave the company in financial constraints.