Managing cash deficits - Overdrafts, short-term loans, and l...

Learning Outcomes

After reading this article, you will be able to explain how businesses manage temporary cash deficits using overdrafts, short-term loans, and lines of credit. You will identify differences between these facilities, describe their accounting treatment and related risks, and apply these concepts to exam-style questions in the context of the ACCA Financial Management syllabus.

ACCA Foundations in Financial Management (FFM) Syllabus

For ACCA Foundations in Financial Management (FFM), you are required to understand how businesses respond to short-term cash shortages and report related liabilities. You should focus on:

• Identifying methods for meeting short-term cash deficits, including overdrafts, short-term loans, and lines of credit
• Understanding the distinction between current and non-current liabilities in financial statements
• Describing the nature and risks of each funding method, including interest obligations and security
• Applying accounting entries for raising and repaying short-term finance
• Recognising how these facilities affect the cash at bank and liability balances

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is most likely to be classified as a current liability?
   1. Five-year bank loan
   2. Bank overdraft
   3. Debentures
   4. Share capital

2. True or false? A bank overdraft must only be reported in the financial statements if it is overdrawn at the reporting date.

3. Why might a company favour a line of credit over arranging a series of individual short-term loans?

4. Briefly explain how interest is typically charged on a bank overdraft compared to a short-term loan.

Introduction

Many businesses experience periods where cash payments exceed cash receipts, resulting in a temporary deficit. It is essential for financial managers to ensure the business can meet its short-term obligations and avoid insolvency. This article describes the main tools used for managing cash deficits: overdrafts, short-term loans, and lines of credit. You will learn their features, accounting implications, and risks.

METHODS FOR MANAGING CASH DEFICITS

Effective cash flow management protects a business from failing to pay employees, suppliers, or taxes when due. When facing a cash shortfall, several funding options are available.

Bank Overdrafts

A bank overdraft allows an account holder to withdraw more money than is available in their bank account, up to an agreed limit. Overdrafts are usually repayable on demand and are among the most flexible short-term finance solutions. The interest is calculated daily on the amount overdrawn, and banks may also apply fees or arrangement charges.

Key Term: bank overdraft
A facility that permits an account holder to withdraw funds exceeding their current balance, resulting in a negative (overdrawn) balance up to an agreed limit with the bank.

Short-term Loans

A short-term loan is a formal borrowing arrangement, typically repayable within a year. Unlike overdrafts, the funds are provided as a lump sum and repaid according to a fixed schedule, which may be a single payment or several instalments. Interest is charged on the full amount of the loan, regardless of whether all funds are used throughout the period.

Key Term: short-term loan
A fixed-amount borrowing arrangement, usually with a maturity of less than twelve months, repaid according to agreed terms and subject to interest charges.

Lines of Credit

A line of credit is an agreement between a business and a lender to provide access to funds up to a specified limit, which can be drawn and repaid as needed within the period—often one year. Interest is charged only on the amount actually drawn, not the entire facility.

Key Term: line of credit
An arrangement with a lender that allows a business to borrow up to a specified limit at any time within an agreed period, with interest payable only on amounts drawn.

ACCOUNTING FOR SHORT-TERM FINANCING ARRANGEMENTS

All these funding methods have specific accounting treatments and implications for financial statements.

• Bank overdrafts and short-term loans are classified as current liabilities on the statement of financial position. Cash received appears in the bank account (which may show a negative balance if overdrawn), while the corresponding liability is recorded.
• Lines of credit are disclosed similarly; only the amount actually drawn is shown as a liability.
• Interest on overdrafts and loans is recognised as a finance cost in the statement of profit or loss.

Exam Warning Remember: only the drawn (used) portion of an overdraft or line of credit is shown as a liability—not the full facility available!

Worked Example 1.1

On 31 December, Beta Ltd has a cash at bank balance of (2,500) (i.e., overdrawn). The bank statement shows an agreed overdraft limit of \10,000, but at year-end, this limit is not exceeded. How is this presented in the financial statements?

Answer:
The $(2,500) adverse cash at bank balance is reported as a current liability on the statement of financial position (so 'Cash at bank and in hand' may be negative or shown separately as 'Bank overdraft'). The overdraft limit itself is not disclosed—only the actual amount overdrawn.

Worked Example 1.2

Gamma Ltd draws $5,000 from its approved line of credit during the year, with an overall limit of $20,000. At year-end, they have not yet repaid the $5,000. How should this be recorded?

Answer:
$5,000 is shown as a current liability (either as 'bank overdraft' or 'loans payable') and the cash received is included in the cash at bank account (which may be positive or negative overall). The undrawn part of the line of credit does not appear in the financial statements.

FEATURES, ADVANTAGES, AND RISKS

Each financing method has benefits and drawbacks which may impact business risk:

• Overdrafts: Flexible, quick to arrange, but can be withdrawn by the bank at short notice. Interest rates are often higher than for loans.
• Short-term loans: Provide certainty over repayment terms and interest, but require negotiation and may include arrangement fees. Early repayment may incur penalties.
• Lines of credit: Offer flexibility to draw or repay funds as needed, typically with lower fees than multiple individual loans, but may require regular review or security.

Revision Tip Carefully distinguish between overdraft (flexibility, repayable on demand), short-term loan (fixed sum, agreed term), and line of credit (maximum amount, flexible drawdown). Misclassification in financial statements can cost easy marks.

Worked Example 1.3

Delta Ltd is deciding between a $10,000 overdraft and a $10,000 short-term loan to cover a temporary cash shortfall. Explain two factors management should consider in choosing which facility to use.

Answer:
(1) Repayment Flexibility: Overdraft is repayable on demand and suits unpredictable cash flows; short-term loan requires fixed repayments.
(2) Cost: Overdraft interest is charged on the daily overdrawn balance; short-term loan interest applies to the entire loan regardless of usage.

COMPARING SHORT-TERM FACILITIES

Summary

Overdrafts, short-term loans, and lines of credit are key methods for overcoming temporary cash deficits. Each has distinct features and accounts as a current liability. Choice of facility will affect business risk, flexibility, and the interest incurred.

Key Point Checklist

This article has covered the following key knowledge points:

• Differences between bank overdrafts, short-term loans, and lines of credit for managing cash deficits
• Accounting treatment of each facility in the financial statements as current liabilities
• Main risks and features of each finance method
• When to use each type of short-term finance
• Impact on interest expense and cash position

Key Terms and Concepts

• bank overdraft
• short-term loan
• line of credit