Is the Overdraft Alive and Well? Part 1

Over the next couple of weeks, I’m going to look at the ‘good old fashioned’ overdraft and ask: “Is it still a good funding option for a business owner to consider?”
I remember a bank manager saying to me once: “The problem with providing an overdraft facility to a business owner is that they tend to view it as a target rather than a facility”.

Whilst that comment may seem a little harsh on business owners, nevertheless the point is well made. Too often business owners get an overdraft facility agreed from their bank and then immediately use the full facility, going up to or very close to the limit of the overdraft.

And what happens over time, is that the overdraft doesn’t come down, instead it becomes “hard core” borrowing.

This is not an overdraft but a loan, and therefore not what an overdraft is for or how it is meant to be used.

If you take out an overdraft and immediately go up to or close to the limit of the overdraft, then an overdraft is not what you needed in the first place and there are better funding options that you should be considering.

All of that said, what is an overdraft? What and how should it be used? And what are the advantages and disadvantages of an overdraft compared with other funding options that might be available?

Firstly, let me explain what an overdraft is. Put simply, an overdraft is a facility that is attached to the main business bank account.

When a lender provides a business with an overdraft facility, it will normally come with an agreed limit which the business can borrow up to. So, for instance, if your bank agrees an overdraft limit of £20,000, then it means you can go “overdrawn” on your business current account up to £20,000 without running the risk of missed or returned payments on direct debits and standing orders.

Business overdrafts are a very common way of financing SME’s (small and medium-sized enterprises) and are ideal for those businesses with fluctuating working capital requirements. Overdrafts are sometimes provided over a fixed period, or more commonly as a rolling facility with no end date, although typically there will be a review date on a regular basis which is usually every 6 or 12 months.

Overdrafts can be authorised or unauthorised.

The former is a pre-agreed facility and will be offered at a lower interest rate. Unauthorised overdrafts on the other hand are exactly that. They happen when the business either goes overdrawn on the account without prior arrangement with the bank or when the agreed overdraft limit is exceeded. In either case, the overdraft is unauthorised and will attract higher interest rates and increased fees when compared with a normal authorised facility.

It is therefore prudent not to go into an unauthorised overdraft, not least because you run the risk of bounced direct debits and standing orders, but also because of the increased costs associated with an unauthorised overdraft.

Overdrafts are commonly used by a business to ease pressure on working capital requirements and as a ‘back-up’ for unexpected costs or expenditure. They are therefore ideal for any business which experiences fluctuation in their working capital requirements.

The clue to whether a business needs an overdraft, and whether it is being used correctly can always be gleaned from looking at the business bank statements. If a business’s bank statements indicate that much of the time there are cash balances and the account is running in credit, with occasions when the business “dips into overdraft” before coming back out again and into credit, then that is an overdraft facility that is being used correctly.

In this scenario, the business in question is using their overdraft to help them meet the working capital fluctuations that occur in the day-to-day operation of the business.

As a result, it is most probably the best funding option for that particular business.

If on the other hand, when I look at the bank statements for a business and see that the account is constantly in overdraft, with a level of “hard core” borrowing, then that is a situation where an overdraft is not being used correctly.

In that situation, there are better and more cost-effective ways that the business in question could be funded.

That being the case, I would normally. after discussions with the business owner, suggest a restructuring of the overdraft on to a business loan for an agreed term. The business owner then has the option to re-negotiate with the bank for a smaller overdraft facility to meet any working capital requirements, if indeed an overdraft is even needed at that point.

The overdraft is still very much a part of the funding solution for business owners, and next week I’ll look in more detail at the costs associated with an overdraft as well as the various “pros and cons”.