Q&A - Explain what a bank overdraft is

A bank overdraft is flexible borrowing facility on a bank current account which is repayable on demand.

A bank overdraft does not actually result in cash flowing into a business. Instead the business is allowed to let its bank account become “overdrawn” – i.e. in the red, up to a maximum amount.

For example, a business may find that it expects to have a cash shortfall of £15,000 during a month as a result of paying wages and suppliers. If the bank allows it, the overdraft facility can be used to temporarily “borrow” the cash from the bank.

A good way to think about a bank overdraft is to imagine a bank current account which can have either a positive (i.e. cash in the bank) or negative (i.e. cash owed to the bank) status.

The maximum amount that the bank account can go into the red is known as the overdraft facility.

How much interest does a business pay on a bank overdraft? It depends on what the bank balance is day to day. Interest is calculated daily, usually at a high rate, on the overdrawn balance.

You can see that a bank overdraft is a flexible form of finance. A business only pays interest on the amount of the overdraft facility used.

However it is important to realise that a bank overdraft is essentially a short-term source of finance designed to cover temporary shortages of cash. If a business finds itself using the expensive overdraft month after month, then it ought to consider whether a cheaper, long-term bank loan would be a more suitable source of finance.