BUSINESS OVERDRAFTS GUIDE

business-overdrafts

What is a Business Overdraft?

A business overdraft is a revolving loan that has a credit limit and allows a business to draw on funds up to a pre-agreed credit limit. A business overdraft works in much the same way as a business credit card, but there are typically no minimum monthly payments as long as the balance on the account has not reached the predetermined credit limit.

How Do Business Overdrafts Work?

A business overdraft typically attaches to the main transaction account of the business and allows the account to be drawn past a zero balance and down to the predetermined credit limit of the overdraft. Some banks also offer a “temporary overdraft” where the business can draw past zero on their account for a limited period of time (e.g. 1 month) but then must bring the account back to order within the specified period or incur additional fees. Banks vary in their policies on temporary overdrafts, but many restrict the number of times a business can use a temporary overdraft in a given 12 month period.

Business Overdrafts offered by the Banks in Australia typically require security in the form of residential or commercial property or alternatively to be secured against term deposits or other cash assets held with the Bank.

When Should Business Overdrafts be Used?

Business Overdrafts are good for the following:

  • Businesses with lumpy cashflows, for example contracting businesses where staff are paid weekly but customers may pay only on job completion
  • Funding general working capital (meeting the timing gap between expenses and customer payments)
  • Situations where additional cash is needed quickly and for a relatively short time frame. For example, when a business has the opportunity to purchase discounted stock
  • Meeting one-off unexpected operating expenses, assisting with cashflow during periods when business is slow (for example the Christmas to New Year period for many businesses)

Business Overdrafts are generally not well suited to the following situations:

  • Financing long term capital expenditure (i.e. equipment purchases)
  • Everyday use where there is no or little working capital in the business

What Types of Business Use Business Overdrafts?

  • Recruitment firms – to fund staff salaries until receipt of commissions
  • Project based businesses – to fund operations until payment receipt on project)
  • Exporters – to fund shipping of goods
  • Importers – to fund purchase of goods

Here are a few examples of situations that are well suited to Business Overdrafts:

Example 1: A seasonal business that generates most of its revenue in the winter could use a Business Overdraft to fund business activities in the slower summer months

Example 2: A business could use a Business Overdraft to fund marketing and sales related to a new product launch. The upfront expenses could be funded by the drawdown on the overdraft with the overdraft paid off relatively quickly once customer sales are made.

Example 3: An importer that needs to pay for goods in China and then has a 60-90 day wait before being in a position to sell the goods could use an overdraft to fund the upfront investment in the inventory.

Where does the Business Overdraft fit into a Businesses’ Overall Financing Strategy?

Business Overdraft are highly flexible funding solutions that are relatively cheap option if the businesses funding requirement change regularly (i.e. there is volatility in business cash flow). However, the overall interest rates on business overdrafts are relatively high and this means it should not be used as “core debt” or to be perpetually drawn. If core debt is to be used in a business’s capital structure then this is best served by a term loan or similar facility.

What Are the Alternatives to Business Overdrafts?

Invoice discounting, debtor finance and trade finance are financing options that can also provide a great deal of flexibility. These options are however “fit for purpose” financing options. Invoice discounting is only available for businesses that issue invoices (and typically only when the debtors are high credit quality) and trade finance is typically only available for importers or businesses that purchase large volumes of high value items (items that have a high liquidation value in event of default). In short, trade finance and invoice discounting are suited to funding working capital requirements of certain businesses whereas business overdrafts are more flexible and have a broader range of uses. Business Term Loans are typically not a good alternative for Business Overdrafts for reasons described in the Business Term Loans guide.

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Trade finance and invoice discounting are suited to funding working
capital requirements of certain businesses whereas overdrafts
are more flexible and have a broader range of uses

Both invoice discounting and trade finance is explained in greater detail in other guides. Feel free to click on the guides to understand these products in more detail.

Business Overdraft Fees

Fees are charged on the credit used and typically applied daily. In addition, some Banks may also charge a line fee, commitment fee or an undrawn facility fee. This fee can vary from 0.25% to 2% and is applied to the overall credit limit (or undrawn portion of the credit limit) and not the drawn amount as is the case with the interest charges.

What Are Some of the Pitfalls of Using Business Overdrafts?

Qualifying for the facility in the first place! Banks typically require property security in order to provide a business with a Business Overdraft. In addition, the application process usually requires 3 years of financial statements and a track record of strong cash flow and financial performance.

The main pitfall with Business Overdrafts is in business owners misusing them. The most common misuse is to run the overdraft as core debt and have the overdraft continually drawn.

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