Working capital financing choices - Overdrafts, lines of cre...

Learning Outcomes

After reading this article, you will be able to explain the main types of short-term working capital financing options, particularly overdrafts, lines of credit, and bills of exchange. You will understand their features, how they compare, and the considerations for choosing among them, all from the standpoint of an ACCA Financial Management (FM) exam candidate.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand the options available for funding working capital. In particular, you should focus your revision on:

• The main features and uses of short-term sources of finance, including overdrafts, short-term loans, lines of credit, and bills
• The cost, advantages, and disadvantages of different short-term borrowing options for managing liquidity
• The impact of funding choices on business risk and financial position
• How to distinguish between permanent and fluctuating current assets with respect to funding strategies
• The practical considerations and risks involved when selecting short-term finance methods

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 statement best describes a bank overdraft?
   1. A fixed-term loan that is repayable on maturity
   2. A facility that allows a firm to withdraw more funds than its account balance up to an agreed limit
   3. The granting of trade credit by suppliers
   4. A formal document guaranteeing payment at a future date

2. What is a key difference between a line of credit and an overdraft?

3. True or False? Bills of exchange are negotiable instruments often used to provide short-term trade finance.

4. Briefly explain why a company might use an overdraft rather than arranging a short-term loan.

Introduction

Efficient management of working capital often requires external finance to cover timing differences between cash inflows and outflows. Businesses use a range of short-term financing tools to manage liquidity, support operations, and address cash flow fluctuations. The choice between overdrafts, lines of credit, and bills of exchange depends on their relative cost, flexibility, and suitability for a given situation. Understanding these methods is essential for effective cash management and for ACCA FM exam success.

Key Term: overdraft
An agreement with a bank permitting a business to withdraw more money from its account than is available, up to a specified limit, usually on a short-term, repayable-on-demand basis.

Overdrafts

A bank overdraft is one of the most flexible forms of short-term borrowing. Banks allow a company to overdraw its account up to a pre-agreed limit. Interest is paid only on the amount used, and the overdraft is repayable on demand.

Main features:

• No set repayment schedule—the bank can ask for repayment at any time
• Interest is variable and often higher than many other forms of finance
• Security may be required, especially for larger facilities
• Used for day-to-day liquidity management, covering cash shortfalls and timing differences in receipts and payments

Pros:

• Flexibility—borrow as needed, within the limit
• Only pay interest on the amount actually used
• Administration is minimal once the facility is in place

Cons:

• Can be withdrawn at short notice by the bank
• Interest rates are typically variable and may be high, especially if the business is perceived as risky
• Often secured by a floating charge over assets

Key Term: line of credit
A pre-approved arrangement with a bank or lender enabling a business to borrow funds up to a certain amount, at any time within an agreed period, usually with more formality and sometimes for longer periods than an overdraft.

Lines of Credit

A line of credit is similar to an overdraft but usually involves a more formal agreement with the bank. A specified borrowing limit is set for a defined period, and the company can draw and repay funds as needed.

Main features:

• Set facility period, often three to twelve months
• Borrower can use and repay funds flexibly, up to the limit
• Interest charged only on the funds drawn
• May be subject to arrangement fees and regular reviews

Comparison with overdrafts:

• Generally more formalised, with clear contractual terms
• May require advance notice for withdrawals
• Can provide greater certainty that funds will be available when needed

When suitable:

• Businesses with ongoing, but variable, short-term funding requirements
• When a more secure or committed facility is preferred over the on-demand nature of overdrafts

Worked Example 1.1

A manufacturer needs fluctuating amounts of finance to cover increased production in the run-up to major holiday sales. The management is considering a bank overdraft versus a line of credit.

Which option is more appropriate if the business is concerned about the facility being reduced at short notice?

Answer:
A line of credit is usually more secure for the borrower because, unlike an overdraft, it is contractually committed for its term. If losing access to funds at short notice is a risk, a line of credit is preferable.

Key Term: bill of exchange
A negotiable instrument issued by a business ordering a buyer to pay a specified sum at a future date—commonly used in trade finance for short-term borrowing.

Bills of Exchange

Bills of exchange are formal documents that enable a company to obtain cash quickly and reduce credit risk from trade receivables. After a sale, the seller draws up a bill ordering the buyer to pay at a set future date. The seller may choose to "discount" the bill with a bank in exchange for immediate cash, less a discount fee.

Main features:

• Used to bridge the gap between delivery of goods and payment by the customer
• Can be transferred to third parties or discounted at a bank
• Legally enforceable (if accepted by the buyer)

Uses:

• Short-term trade finance, especially for exporters and importers
• Businesses wanting to convert trade debts into cash before maturity

Pros and cons:

• May improve cash flow and reduce collection risk
• Discounting takes a fee; cost may be higher than some alternative borrowing
• Less common in local trade, but still widely used in international transactions

Worked Example 1.2

An exporter sells $100,000 of goods on 60-day terms and draws a bill of exchange accepted by the buyer. The exporter discounts the bill with their bank at 8% annual rate.

How much cash does the exporter receive immediately?

Answer:
For a 60-day, $100,000 bill at 8% p.a.: Discount = $100,000 × 8% × (60/360) = $1,333
Cash received = $100,000 – $1,333 = $98,667

Funding Decisions: Comparing Options

Selecting the right method depends on factors including:

• Speed of access: Overdrafts can be used instantly within the limit; lines of credit may take time to draw down; bills rely on customer acceptance and bank processes.
• Cost: Compare interest rates and fees charged by banks for each option.
• Flexibility: Overdrafts allow ad-hoc use; lines of credit can be more committed; bills of exchange use is limited by sales made on credit and customer acceptance.
• Security/Risk: Overdrafts and lines may require security; bills may carry collection/legal risks if unpaid.

Exam Warning

Common error: Confusing overdrafts, lines of credit, and short-term loans. Overdrafts are on-demand and variable, lines of credit are typically committed facilities, and short-term loans have fixed terms and repayment dates.

Revision Tip

In calculations, always check: Is interest charged only on the amount used (overdrafts, lines of credit), or on the full amount (loans)? Read the exam scenario carefully.

Summary

Overdrafts, lines of credit, and bills of exchange are essential options for financing short-term working capital needs. Each has specific features, costs, and risks. The suitable choice depends on company circumstances, the required speed, the flexibility needed, and the level of security or commitment desired. Effective working capital management requires understanding the differences and making informed decisions.

Key Point Checklist

This article has covered the following key knowledge points:

• Define overdrafts, lines of credit, and bills of exchange as working capital funding sources
• Identify the advantages, disadvantages, and typical uses of each method
• Compare criteria for choosing between short-term funding options
• Recognise the impact of these choices on cash flow, cost, and financial risk
• Apply these concepts to ACCA FM exam scenarios

Key Terms and Concepts

• overdraft
• line of credit
• bill of exchange