Loans and Overdrafts are two basic products offered by banks and financial institutions for funding a company’s capital needs, but both of them are very different funding products.
Difference between Overdrafts and Loans
Let us understand the key differences between overdrafts and loans–
A loan is a lump sum amount that a bank lends to an organization or an individual for a very specific purpose, and that amount has to be repaid over time.
Overdraft is a facility wherein a current account holder with the bank gets to withdraw money in excess of the effective credit balance in their current account.
A loan or a term loan is extended to a business for a specific purpose, for example – buying a new machinery, setting up a new factory, etc.
Overdraft facility is extended to finance day to day cash operations of the business such as wages, bill payments, etc.
A loan is usually extended for a longer period of time say for 5, 10 or 20 years.
Overdraft facility is used for short-term borrowing say 15 days to 6 months.
When a company intends to borrow term loan, it goes through an internal process of recognizing the need and building repayment schedule. The loan’s cost to the company over the years and the loan’s value addition to the profitability of the business is also considered. This is because the loan liability is usually big and for a longer period of time.
Conversely, no such internal planning is done when using the overdraft facility. In fact, sometimes it may happen that the company has used the overdraft facility and repaid it as well and realizes it at the end of the accounting year.
While extending a loan, the bank usually asks for a collateral against the loan.
No collateral or security in required availing an overdraft facility.
A company must have a current account with the bank to avail overdraft facility from the said bank, whereas there is no such requirement when it comes to loans. Companies can borrow loans from any banks or financial institutions indifferent to whether they have a current account with the bank or not.
A loan is assessed on various criteria such as the viability of the investment, financial health of the borrowing company and the macro business environment. Sometimes the borrower also secures the loan with his personal guarantee. The banks are very vigilant when it comes to sanctioning loans.
However, in bank overdraft, the assessment criteria’s are very different. They gauge the borrowers on their credit score, loyalty to the bank and average balance in their bank account in last few months. Even though the bank is careful about extending the overdraft facility, it is comparatively lenient than loan extensions.
The repayment of a loan is through regular EMI (monthly installment) which includes both principle and interest payment. This EMI is calculated from the amount of loan and time period, even before the loan is extended. The borrower of the loan already knows exactly the amount payable every month for x number of years as repayment.
Repayment of the overdrawn amount is very different from a loan. The company repays the overdrawn amount when it has the convenience of additional cash liquidity. In most cases the company doesn’t even have to make a special provision for repayment. The repayment is taken care of in the regular cash flow cycle of cash outflow and cash inflow.
With regards to the loan, the interest rate is calculated on the amount sanctioned by the bank, regardless of whether this amount is used or not. Also, the entire duration of the loan is considered for interest calculation. For example, if the loan sanctioned is of US$ 5000.00 for 2 years at 5% simple interest per annum, then the interest rate will be US$ 5000.00 (amount) X 5/100 (interest rate) X 2 (duration) = US$ 500.00
In overdraft, the interest rate is calculated only on the amount overdrawn by the account holder regardless of the sanctioned limit. Also, the overdraft interest is calculated only for a number of days the account is overdrawn. For example, a company has a current account balance of US$ 10,000.00 and an overdraft limit of US$ 15,000.00 at an interest rate of 5% per annum. Company uses US$ 13000.00 for 15 days and deposits US$ 3000.00 in its bank account. So the interest rate would be US$ 3000.00 (amount) X 5/100 (interest rate) X 15/365 (duration) = US$ 6.16.
Effect on Ratios
Use of overdraft facility affects the current ratio of an organization as it creates short-term liability for the company. It will also subtly affect efficiency ratios such as receivables turnover ratio and collection period.
On the flip side, loans affect leverage ratios such as debt-to-equity, debt-to-asset, etc. This is because loans create long-term debt for the borrowing company.
Sometimes companies also choose the type of product that makes their balance sheet look good. This is because company valuation also affects the profitability of the company to a great deal. Especially for the listed companies, good balance sheet may convert into favorable credit terms, better interest rates and more capital availability.
This brings us to the conclusion that even though both loans and overdraft facilities are used to fund business, it is crucial to consider many factors when choosing the type of funding.