What Is the Relationship Between Bank Overdraft & Working Capital?
Analyzing the balance sheet of a company will help an analyst understand what kind of financial shape a company is in and what kind of assets the company owns. One metric of the financial health of a company is working capital — or how much money the company has on hand for daily operations. One account in working capital on the liabilities side is the bank overdraft, which provides emergency funds if a company's bank account can't cover expenses.
The simplest way to determine working capital is to subtract current liabilities from current assets. The working capital is the company's assets involved in the day-to-day operations of a business. To find the more accurate working capital figure, an analyst subtracts the excess cash from a company's current assets. The excess cash is the cash on a company's balance sheet not needed for the operations of the business.
A bank overdraft is a service provided by a bank that gives an entity access to cash if the cash in the entity's account runs out. This is useful if a company does not keep a lot of cash on its books. This creates an emergency backup plan if that company loses track of its cash. The payments will continue processing even if the bank balance falls below zero and the company will be able to continue operating smoothly for a short time. This will give the company an extra day or two to find cash to pay back the bank.
If a company's bank account goes into overdraft, it increases the company's assets and liabilities and keeps the balance sheet in balance. The amount the account is overdraft by is added to the company's current assets and is also added into a company's current payables account as bank overdrafts. The working capital does not change because the same amount is added to each side of the equation. Therefore, the bank overdraft does not impact a company's working capital.
A company has zero cash on its balance sheet and current assets of $1 million. The current liabilities total $500,000. The working capital equals current assets of $1 million minus current liabilities of $500,000 for a total of $500,000. The company overdraws its bank account by $50,000. The new current assets total $1 million plus $50,000 for a total of $1.05 million and current liabilities equal $500,000 plus $50,000 for a total of $550,000. The new working capital equals $1.05 million minus $550,000 for a total of $500,000.