Business overdrafts – what you need to know
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When it comes to managing cash flow in your business, a business overdraft is an essential tool for providing flexibility in the face of economic ups and downs.
Small businesses rely on cash to run day to day operations, but unexpected circumstances, such as late payments or surprise bills can come at any moment. A business overdraft is a financial cushion to help you absorb unexpected costs and maintain business continuity.
Business overdrafts are similar to personal overdrafts, but the eligibility requirements are different and there are additional factors to consider. This article explains how business overdrafts work, how to use them effectively, the fees involved, the advantages and disadvantages, and what alternatives are available.
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What is a business overdraft?
A business overdraft is a form of credit accessed through your business bank account. It provides additional funds, up to an agreed amount, when your account is no longer in credit. The overdraft facility helps with cash flow shortfalls, giving you more financial flexibility and security.
So, what might you use a business overdraft for?
Typical examples include:
- Settling invoices that you owe or bridging gaps caused by overdue invoices owed to you.
- Using a business overdraft to pay wages, buy essential stock (perhaps to meet a spike in demand), or manage supply chain issues.
- Managing unexpected costs, such as repairs and replacing equipment, are other reasons.
An overdraft provides a financial safety net for all these things, but there are also valuable alternatives.
How does a business overdraft work?
A business overdraft allows you to access funds when your bank balance drops below zero.
Effectively, this is a loan which you must pay back. And like a business loan or a business credit card, you must pay interest on the sum borrowed. Once you repay the outstanding figure and your account is no longer in debit, you stop paying interest.
Overdrafts have limits, which are set by the overdraft provider (usually your bank). Limits can vary from hundreds of pounds to millions and will be determined by several factors, including your business turnover and credit history.
If your cash flow circumstances change, it’s possible to increase your overdraft limit. However, the provider will only do this if it believes the business can pay back the amount borrowed.
If the bank has concerns about you repaying the overdraft, or you’re asking for a large sum, the business overdraft might have to be ‘secured’.
What’s the difference between secured and unsecured business overdrafts?
Depending on your circumstances, you may benefit more from a secured or unsecured overdraft, though in some cases, the choice will be made for you by your provider.
Secured business overdraft
With a secured business overdraft, you must use a business asset (such as your commercial property or equipment) as security. If you have a secured overdraft and can't clear it within a defined period, the bank could sell your asset to recoup the money you owe.
Unsecured business overdraft
As the name indicates, an unsecured overdraft doesn’t require an asset as guarantee. However, while this may seem preferable, your provider will likely try to manage risk through an alternative route, such as a higher interest rate or a lower lending limit.
What are the advantages and disadvantages of a business overdraft?
Advantages:
- A short-term and accessible funding solution that can suit small businesses and start-ups in need of financial support
- Typically, straightforward to apply with funds available quickly
- Flexible payment terms may be available, enabling you to clear the debt when cash flow allows
- You pay interest only on the overdrawn balance, though some will also require an additional fee.
- You can take as much or as little as you need from the agreed overdraft amount
Disadvantages:
- Charges may apply if you miss a payment or are late paying, which could affect your credit score
- Business overdrafts usually have higher interest rates than business loans and alternative forms of borrowing
- Overdrafts can be called in at short notice
- Overdraft amounts are likely to be smaller than business loans
- Overdrafts are available only from the bank that provides your business account
- Overdrafts often have a variable interest rate
Shoot for the moon with your business. Image: Jakob Owens
How to get a business overdraft
Normally, business overdrafts are available only from the bank that provides your business account. You can usually apply by visiting your bank in person, phoning, or applying online.
What are the criteria for a business overdraft?
To qualify, you’ll need to meet your bank’s eligibility criteria. The bank will review your business and its financial history. To check you’re a reliable borrower, your personal and business credit history will also be reviewed.
As part of your application, you may have to outline how you’ll use and repay your overdraft. The larger the overdraft, the more details are usually needed. If your business overdraft application is declined, there are alternative ways to fund your business.
What’s the difference between formal and informal business overdraft requests?
A formal business overdraft request would involve either an initial meeting in person at your bank to discuss a possible overdraft, or a phone call to discuss the overdraft.
The important point is that you’re seeking prior agreement to go overdrawn up to a set limit. The discussion would cover the interest rate charge, the duration of the business overdraft, and any other financial details relevant to your circumstances.
In contrast, an informal business overdraft request would be sought if you were to go overdrawn or exceed your agreed overdraft limit before contacting your bank first.
If you go overdrawn without having an agreed business overdraft, you’ll be charged a fee and interest on the amount exceeding your limit. The interest is likely to be much higher than the interest charged on an agreed business overdraft.
If you exceed the limit on an agreed business overdraft, you would probably incur a fee and be charged a much higher interest rate on the amount exceeding the authorised limit.
What are the alternatives to a Business Overdraft
If your business needs a cash flow boost, a traditional overdraft might not always be the best fit. Here are some alternative options to consider:
Invoice Finance
Instead of waiting for customers to pay invoices, invoice finance lets you unlock a significant percentage of those outstanding funds immediately. This suits businesses with healthy invoice volumes but delayed payment cycles, offering faster cash flow without the ongoing commitment of an overdraft.
Bridging Loans
Bridging loans are short-term, designed to "bridge" a gap until longer-term financing is secured or an asset is sold. As such, they’re best suited for time-sensitive scenarios where you have a clear plan for repaying the loan quickly (e.g., property purchases with timing issues).
Merchant Cash Advances
Businesses taking card payments can secure an advance against future sales as a merchant cash advance. Here,repayment comes directly from a percentage of card transactions.
Revolving Credit Facility
These work similarly to an overdraft in allowing you to borrow up to a limit, pay back, and borrow again. However, a revolving credit facility may have a longer approval process than a traditional overdraft.
For short term funding needs, an iwoca Flexi-Loan is a new alternative to a business overdraft for those needing to borrow between £1k and £500k for up to two years. You can apply in minutes, there are no early repayment fees and you have complete transparency about your options.
Find out how much you could borrow now without affecting your credit score.
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