What Is The Effect Of An Overdraft On The Balance Sheet?

There are two key aspects to consider in a business balance sheet, how efficiently it is funded ("Funding") and how efficiently it is operated ("Operations). Both are important but separate parts of a business; the bank overdraft is part of funding. Changes to funding arrangements do not impact on operating performance.

Traditionally accounting balance sheets are arranged into Assets, Liabilities and Equity in accordance with the balance sheet equation i.e. Assets = Liabilities + Equity. With a two column format, Assets are in the left column and Liabilities and Equity on the right. In a traditional balance sheet Current Assets may contain cash at bank and Current Liabilities may contain entries for bank overdraft. Both Current Assets and Current Liabilities are components of Working Capital which is the operational aspect of the business. In traditional accounting format it can therefore be difficult to distinguish funding from operations.

However the presence or absence of an overdraft only affects the funding aspect. This is clearly seen if the format of the balance sheet is rearranged to reflect the separation of Finance and Operations. In this financial analysis format the left column contains the funding entries (Debt and Equity), and the right column the operational entries (Working capital and Non-current assets) . Instead of cash and overdraft being included with Working Capital they are moved to the Debt section in the left column. The Debt section includes cash, bank overdraft and long term debt. All cash assets or cash liabilities are shown as debt (cash is regarded as negative debt).

In this format you can clearly see what effect an overdraft has on the balance sheet. An overdraft will raise debt. The overdraft affects the Income statement because debt incurs interest (an expense) so interest payments will rise, there will be less profit and therefore less tax to be paid. The retained income entry on the balance sheet (under Equity) will reflect this. However nothing on the Operations side of the balance sheet will be affected by whether the operations are funded by debt or equity or both.

Most businesses are financed by a combination of equity and debt. Exactly what debt/equity mix (leverage) is best for the business is part of the funding strategy determined by management.