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Funding options overdrafts

Overdrafts can provide a cost-effective solution to short-term finance issues. Check out the basics as to how this funding option can benefit your business.

AUTHOR

TREVOR CLAWSON

Business Editor

 

The Basics

The overdraft is one of the most popular sources of short-term business finance. Put simply, the overdraft is a borrowing facility attached to a current account. Within the constraint of an agreed limit, the business can draw on the facility whenever required. Thus, if there are insufficient funds in the account to, say, pay a supplier, the overdraft facility provides a source of additional funding to make up the shortfall.

What is an overdraft for?

The overdraft should be seen as a source of short-term finance, best used for smoothing out peaks and troughs in cashflow. Few companies (particularly those in early stage and growth phases) can rely on the cash coming into the business to match outgoings on a consistent and predictable basis. It may be that a sale agreed today with a major client will require spending on new stock or materials. Meanwhile, invoicing and the subsequent payment required to pay for that stock and materials remain several months down the line. If the business is funding itself through revenues alone there may be times when the cash simply runs out. An overdraft prevents this from happening.

Ideally, businesses should take advantage of their overdraft facilities when cash is in short supply and pay back the debt during those periods when revenues are flowing. If the account is permanently overdrawn, however, an overdraft can be an expensive way in which to borrow.

The overdraft shouldn’t be seen as a source of long-term finance. A business seeking cash to fund investment of new equipment, for example, should look to alternatives such as term loans or leasing.

Pros

In the right circumstances, an overdraft provides a low-cost way of addressing cashflow issues. Businesses draw on the overdraft facility when required and are only charged for those periods when the account is in the red. Businesses that use their overdrafts only occasionally incur negligible interest charges.

Unlike a term loan, an overdraft doesn’t lock your company into set monthly or quarterly repayments.

Cons

An overdraft facility won’t necessarily grow with your business. The sum available within the agreed overdraft limit may not provide sufficient working capital to service an expanding customer base. This is because taking on new customers often requires up-front spending ahead of forthcoming revenue. Businesses that exceed their overdraft limits will incur extra charges.

Businesses can re-negotiate their overdraft limit, but this may incur an additional administration or set-up charge. As an alternative, fast-growth businesses may want to consider borrowing against the value of invoices through invoice discounting or factoring facilities. Under these arrangements, the sum available rises according to the value of invoices on the debtor book.

There is a small element of risk associated with overdrafts, in that the terms and conditions usually state that the facility can be withdrawn without notice and any money owing must then be paid back. However, this is unlikely to happen unless the business faces financial difficulties.

The Practicalities

Generally speaking, a lender will charge an arrangement fee for setting up an overdraft and interest will be charged at percentage over the Bank of England base rate. The rates are usually variable and in the current climate you can expect to pay around 5% above base. There may also be a fee payable at regular intervals in order to maintain the facility.

The amount you can borrow (or to put it another way, the ceiling on the facility) will depend on a number of factors. The lender will look at the value of your debtor book (an indicator of cashflow). A bank may take the view that the overdraft ceiling should be 60-80% of debtor book value. Depending on the lender, smaller overdrafts may be available without the need to put up security. Larger sums will typically be secured against assets.

Overdrafts are relatively quick and straightforward to set up when compared with other forms of bank finance (it’s best to allow two to three weeks), but you can’t shop around without also moving your current clearing account.

The Wrap

Overdrafts are a perfect solution for short-term financial needs and if your business account is in the black for most of the time they are a cheap source of funding. If your requirements are longer term, other alternatives should be considered.

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