A bank loan should be drafted in a form that is specifically tailored to the borrower’s needs. This article considers the first type of bank loan which could be used, namely an overdraft. Other types of bank loans will be considered in subsequent articles, namely term loans and revolving facilities.
The basic function of an overdraft is to solve short-term cash flow problems. It is sometimes referred to as a "working capital facility" as it provides access to cash to meet any temporary shortfalls in working capital.
An overdraft will generally be an uncommitted facility. (An uncommitted facility is one that allows the lender discretion for advancing money to the borrower or the lender can refuse to lend at all.)
An overdraft is repaid on demand, i.e., the lender can demand repayment at any time. This makes it an unsuitable form of borrowing for some transactions, for example, it would be inappropriate to use an overdraft to fund a major acquisition. One effect of the "on demand" nature of an overdraft is that it is a current liability for the purpose of the borrower’s balance sheet. The on demand nature of an overdraft is not as onerous as it may suggest as there generally will be an understanding that the lender will not demand repayment of the overdraft unless and until the borrower’s financial position or activities give it cause for concern.
Advantages of an Overdraft
An overdraft is usually available from a company’s existing lender. Interest rates on an overdraft are generally higher than those on a term loan but overall may be cheaper as interest is calculated on the basis of the overdraft at the end of each day rather than the maximum of the overdraft limit.
As it is an uncommitted facility, there is no commitment fee to pay. (A commitment fee may be required on “committed” facilities where once the facility agreement has been executed, the lender is under an obligation to advance money when requested by the borrower subject to compliance with certain pre-agreed conditions by the borrower. The commitment fee is calculated as a percentage of the undrawn funds that the lender has to keep committed to the borrower from time to time. The fee covers the costs incurred by the lender in committing funds to this loan which it cannot then lend to anyone else.) An overdraft is usually evidenced by documents in the lender’s standard form.
Disadvantages of an Overdraft
The disadvantage of using the lender’s standard form documents is that there is little scope for amendment by the borrower. The basic flexibility of an overdraft is limited in that an overdraft will always have an upper limit.
In some cases, an overdraft facility may include a "clean-up" provision which requires the borrower to bring the overdraft down to an agreed sum at a specified time of year for a specified period (usually a number of consecutive days). The purpose of a clean-up provision is to ensure that the overdraft is used as intended, namely, to solve short-term cash flow problems.
The main disadvantages of an overdraft are that the lender’s charges are relatively high to reflect the administrative burden of an overdraft and that it is repayable on demand.