An overdraft is a form of bank credit that enables businesses to cover unforeseen expenses by borrowing money from the bank.
Also known as cash credit or bank credit, an overdraft is akin to having a credit card. Under an overdraft agreement with the bank, you can draw upon your operating account up to a specified limit.
This facility serves as an alternative to a conventional loan, offering a practical solution for bolstering a business’s liquidity during short periods. Credit provides stability during periods of delayed customer payments or reduced business activity. The flexibility to choose how to utilise the funds within the set limit is a key advantage.
The bank typically levies interest on the borrowed amount and may charge a small percentage of the total loan amount that can be withdrawn.
See also: What is liquidity
What is an overdraft agreement?
Upon entering into an overdraft agreement with the bank, the parties often stipulate a specific period during which the overdraft is applicable, typically a year. As such agreements are commonly renewed annually, overdrafts are categorised as short-term debts.
While these agreements can be renewed, changes in business circumstances may alter the terms and conditions of the loan. Banks often require some form of security or guarantee, such as inventory, a physical store, or valuable machinery, to safeguard against non-repayment.
Who is an overdraft suitable for?
Overdrafts are particularly relevant for businesses that need to procure goods or materials before receiving payments from customers. This applies to sectors such as construction companies, online stores, and restaurants. However, it can also be a viable option for any business facing fluctuating income and expenses or a challenging financial month.
Overdrafts can be used to fund various expenditures, including purchasing goods, paying salaries, covering rental costs, and more. The income eventually offsets the loan with the bank.
What does it cost to use an overdraft?
Costs vary among banks and depend on the desired credit limit and the security provided. Generally, interest is charged on the borrowed amount, along with a fee for accessing the credit—often a small percentage of the total loan amount. Interest rates may increase for larger credit utilisation, and fixed fees are common.
The bank typically requires security for the loan, such as property, inventory, or customer receivables. Personal guarantors may be held responsible for loan repayment, impacting personal wealth and assets.
There are several solutions to improve liquidity
While overdrafts are a valuable option for businesses with consistent income, there are alternative ways to enhance liquidity:
- Factoring: Outsource the collection of invoice amounts to another company. The factoring company pays most of the amount upfront, charges a fee, and then collects the money from your customers, remitting the remainder to you.
- Invoice Selling: Sell an invoice to another company, receiving the full amount upfront minus a fee. The purchasing company assumes responsibility for following up with the customer.
Recommended reading: The ultimate guide to liquidity and cash flow