Overdraft Finance – Pros and cons

An overdraft is an agreed form of bank finance that permits the account holder to draw on funds in excess of the amount on deposit. Simply put, the customer of a bank keeps making payments up to an agreed limit even if there’s no money in their bank account. It can be a useful form of temporary business funding and there is usually no obligation to use the facility.

A business can arrange for an overdraft facility with their bank as a contingency against a deficit in cashflow. Once the funding limit is set by the bank, cash could be drawn out at any time to cover day-to-day overheads. An overdraft facility could be very useful for businesses that engage in the sale and purchase of goods or services.

The idea behind an overdraft facility is that sometimes businesses need extra cash than they have to deal with various expenses. For instance, a business that experiences a drop in sales in April and May might consider using an overdraft facility to cover payroll and other financial requirements. Also, businesses that trade on credit terms could find an overdraft facility very useful.

How it works?

Step 1 – A funding limit is set by the bank where you are able to be overdrawn in your bank account.

Step 2 – You are then charged interest based on the amount overdrawn and the length of time overdrawn. This rate is usually above the base rate.

Step 3 – You are also charged a regular fee for the use of the facility.

Financing using an overdraft

Overdraft financing is a suitable source of flexible working capital– provided when businesses make payments from their current accounts exceeding the available cash balance. However, in theory, the amount loaned is repayable on demand by the bank.

Banks that offer this service typically have a number of expectations from customers who use it, and it is important to be aware of these expectations before entering an overdraftfacility agreement.

• Overdrafts are practically meant to cover short-term expenses. If your business is relying on using it as a permanent form of finance, you should double-check your finances.

• The total amount you borrow shouldn’t exceed the funding limit set-up by the bank. In cases where you wish to alter the amount of the facility, you could negotiate with the bank.

• The bank may require some security before offering the facility. This mostly applies to large overdraft amounts.

When to arrange an overdraft

The amount of an overdraft depends on the timing of receipts and payments, periodic trends in the sales and just to name a few. Hence all businesses should prepare cashflow projections at least six months ahead. This allows the business to identify potential cash deficits. This projection enables the business to decide what form of business finance will be suitable and of what size.

It’s also recommended to allow a couple of weeks before applying for an overdraft. The bank will need to review the application and might require some additional information such as your forecasts which takes time to process. The bank might also demand some collateral.

Advantages of Overdrafts

• An overdraft is a flexible funding solution – you only borrow what you need at a specific time.
• An overdraft facility improves your cashflow– it allows your business to make necessary payments even when you haven’t received payments.
• Overdrafts are easy and quick to arrange.
• It costs a very minimal fee if you do not use the facility. Also there is no charge for paying off the overdraft earlier than expected.
• The funds could be repaid at your convenience.

Disadvantages of Overdrafts

• Overdrafts sometimes appear to be costly – overdrafts carry interest and fees, sometimes higher than other forms of finance. If you go over the agreed overdraft limit, you risk being charged very high fees.
• Overdrafts are repayable on demand to the bank – banks usually reserve the right to demand that the full overdraft be repaid on request. This may happen if you have broken the terms and conditions of the arrangement. In some cases, you might have to repay the debt within 30 days.
• The size of the overdraft facility is directly linked to the capital in your business.The amount of the overdraft is usually pegged to your account history and financial data, with the goal of ensuring that businesses do not end up borrowing more than they can realistically repay through an overdraftfacility.
• There’s a funding limit set by the bank – the facility does not grow with your business
• Overdrafts often require some form of security – need to be secured against your business’ or owner’s assets, which put them at risk if you cannot meet requirements.
• Banks often seek third party assistance to improve security.
• There’s an arrangement fee for businesses that intend to extend the overdraft. The agreed limit can be re-negotiated with the bank, and some banks are willing to re-evaluate if customers feel that their circumstances have changed.
• The interest rate on the amount borrowed is usually variable, making it difficult to accurately calculate the facility costs
• Overdraft finance is more time consuming if you obtain the facility from a bank where you do not have a current account as you will need to transfer your business’ bank account.

There are alternatives to the traditional bank overdraft that are a good backup to ensure that a business can pay its bills even when they have not received payments from their outstanding invoices. One product of small business finance is called invoice finance (factoring and invoice discounting)

Bear in mind that what starts out as a good deal may change – as may your business needs. It’s worth reviewing your options regularly. Overdraft facilities provide flexibility and cash which can be used to finance a business in cashflow problems. However, other lending instruments may be more practical, and it is a good idea to shop around for the best possible financial arrangements at your disposal or speak to a commercial finance broker. It is important to avoid making a financial choice that would be problematic later in the hurry to access funds to deal with a current problem.

This business advice article from Touch Financial, the UK’s largest invoice finance broker.