An overdraft is a short-term funding option designed to help a business through times when cash flow is low by allowing you to spend more money than you have in the bank. Essentially, it provides instant cash to bridge the gap between incoming and outgoing funds and it is more cost effective than buying on a credit card, where the associated interest rates are far higher.
One of the main attractions of an overdraft is that it provides a safety net. Many companies, even those working almost exclusively in credit, like to have the facility as a back-up.
Is an overdraft right for your business?
A bank overdraft isn't right for every business or every funding requirement - examining the following features should help you to determine whether an overdraft is right for you:
- The amount of the overdraft is a matter for negotiation with the bank and it will depend on items such as your cash flow, the timing of receipts and payments and seasonal trends in sales. You must be careful not to exceed your limit or else you may be hit with a surcharge or refusal to pay by the bank
- Interest is charged on the amount overdrawn and it is usually charged at a rate that is above the Bank Base Rate. The bank may also charge an annual fee for the privilege of having the facility available
- Overdrafts are generally meant to cover short-term financing requirements - they aren't designed to be a permanent source of funding
- Depending on the size of the overdraft facility, the bank may require you to provide some form of security - this could a tangible fixed asset or a personal guarantee.
When you apply for an overdraft facility a bank will want to see evidence from your banking history that can justify your claim. A healthy relationship with your business banker helps however for the bank, the key question that needs to be answered is: does your business have the free cash flow to service the repayment on an ongoing basis? If it does, a facility should be forthcoming, with the amount you can borrow dictated by the level of free cash flow.
Why use an overdraft?
The key benefit of an overdraft is its simplicity. If you need to buy goods or services but don't have the cash available at the time, you can simply dip into the overdraft to fund the purchase.
Flexibility is another key benefit. Although you will agree on a limit when you open your account, it is generally a relatively easy process to change this limit as and when required (provided your bank believes you will be able to pay the increased overdraft back). In some cases you can even request an immediate overdraft limit increase over the phone or online to ensure you don't over-step your limit.
If used wisely, the interest you pay on this facility should be relatively low because you only pay interest on what you borrow for the appropriate period. For example, if you dip into your overdraft by $1,000 and then return your account to credit in less than a week, you will only pay interest on that amount for those few days. Take out a six-month loan for the same amount and you will be up for far more interest.
Use it wisely
It is important that you use your overdraft sensibly and for a specific function. In most cases it is up to you (not your bank) to ensure that you have the appropriate facilities in place to meet your requirements and to make sure limits are changed when needed.
Overdrafts should really only be used to meet short-term working capital requirements. If you're acquiring items such as plant or property, other forms of financing will likely be more suitable.
Managing your overdraft
The secret to managing your overdraft is to keep your business account dynamic. This means you should be moving between being overdrawn and in credit on a regular basis. If you have significant levels of debt or if your account remains overdrawn for an extended period of time, you'd be better off restructuring your finance and moving to a long-term lending facility. As a guide, if your account isn't moving into credit at least once every few months, then you should start thinking about revising your source of funding.
Remember, your bank should keep an eye on things too. Go in and talk to your bank manager and work out what your business needs - business can be unpredictable and the bank is there to give you the financial tools necessary to help you through.
Finally, it pays to manage your finances well. It is often the case that the more financially stable a business, the better the package offered. Also, those who breach their limits can expect to be hit with increased interest rates.