Question

What are the advantages and disadvantages of using short term financing such as overdrafts?

Answer 1

The short-term financing is effective tool to manage working capital. The banks generally provide overdraft facility to cater working capital requirement of entities. In general, the short-term finance is for less than or equal to 1 year. Banks charges interest and fees for providing such finance facilities.

Advantages of short-term finance such as overdraft:

1. Effective cash management: The entities can effectively manage cash if they have running overdraft account with sufficient bank limit. The unknown cash expenses can be tackled easily. The cheque/check payments fall due randomly and such random payment get easily authorized if entities have sufficient balance in overdraft bank account.

2. Easy to avail: Overdraft account can be easily approved from banks on basis good track record. The banks don’t hesitate to extent overdraft facilities for accounts which hold good in their system.

3. Interest cost benefit: The overdraft account holders pays interest for outstanding balance only its better than flat long-term loans hence, interest cost remains low if we compare cost with long term loan or finance.

4. Withdrawals and repayments: Overdraft account can be used with no limit on withdrawals and repayment activities. Multiple withdrawals and repayments can happen in overdraft account.

Disadvantages of short-term finance such as overdraft:

1. Interest rates: Overdraft account leads to unplanned/unknown disbursement for a bank because clients can ask overdraft any time hence, banks charge bit higher cost to their clients.

2. Conditional sanction: In general, banks sanctions such limit with condition of cancellation or reduction of facility at any time depending on banks’ capital requirement.

3. Improper management: Sometimes finance managers don’t effectively manage such facilities and end up paying higher costs to banks. Example: Sometimes its better to give bargain more credit period from creditors but as overdraft accounts are available for use managers don’t bargain effectively.