An overdraft is a form of bank credit that helps businesses cover unforeseen expenses by borrowing money from the bank.
Overdraft is also known as cash credit or bank credit. It can be compared to having a credit card—it lets you draw upon your operating account up to a specified limit.
Having an overdraft on your bank account is an alternative to a conventional loan, and is a practical way to improve your business’ liquidity for short periods of time.
How does an overdraft work?
With an overdraft you can withdraw more money from your accountant than you actually have. You can, for example, withdraw money until you have -$5 000 in your account.
Banks often require some form of security or guarantee to offer you an overdraft agreement, such as inventory, a physical store, or valuable machinery.
The agreement usually covers a year at a time. While the agreement can be renewed, changes in your business’ circumstances might change the terms and conditions of the loan.
The bank typically levies interest on the borrowed amount and might also charge you a small percentage of the total loan amount you have available. How much it costs will vary from bank to bank and depends on how much of a credit limit you want and the security you can provide.
When do you need an overdraft?
Liquidity is used to describe the ability your business has to pay bills from suppliers and cover fixed costs, as well as unforeseen expenses.
If you have clients who pay late or reduced sales in a period, this type of credit can help you get through it.
Overdrafts are particularly useful for businesses that need to procure goods or materials before receiving payments from customers, for example construction companies, online stores, and restaurants. However, it can be a viable option for any business that deals with fluctuating income and expenses or that go through a challenging financial month.
Overdrafts can be used to fund various expenses, such as the purchase of raw materials, wage costs, rental costs, and so on.
Some good alternatives
While overdrafts can be a good option for businesses with inconsistent income, there are other ways to improve your liquidity:
- Cash flow budget: Set up a cash flow budget to get an overview of your business’ liquidity over time.
- Use best practices for invoicing: Shorten the due date on your invoices and follow up on overdue invoices. Use invoicing software to get control of your invoices.
- Consider invoice sales or factoring : Selling invoices to another company and receiving the full amount upfront minus a fee. The purchasing company takes on the responsibility of following up with the customer.