Overdraft financing is obtained by overdrawing the business' bank account so as to make pavements to suppliers or to settle other operating expenses. This facility will enable the business to obtain a short-term loan despite the fact that in theory the amount loaned is repayable on demand.
However interest on overdrafts is usually greater than interest on other loans and banks even charge an overdraft facility fee. The company should therefore put all these in to consideration and make sure that the benefits to be achieved from the overdraft outweigh the costs associated with taking the overdraft.
Also, overdrafts do not cover all financing requirements. The company should therefore assess whether its financing requirements are long-term or short-term. If short-term, then an overdraft can be a right source of funding but if long-term then an overdraft would be an inefficient way to raise funds since the overdraft would be required on demand by the bank. If that be the case the company might go into financial distress and subsequently bankruptcy.
In addition, collateral security might be needed by the bank in the form of a tangible fixed asset or against personal guarantee provided by the directors. It this case, the company should consider the nature of its fixed assets and asses which assets it can put up as collateral. Another determining factor for the overdraft is the firm's cash flows, timing and receipts of payments, sales trends and other cash flows. ...