10 min read11 October 2019
Business overdrafts work by simply enabling you to continue to access funds after your business' account balance drops below zero. Sounds simple enough, but here's the big picture.11 October 2019
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As the saying goes, cash is king. Therefore, effectively managing your cash flow is a key to the success of your business. That’s why business overdrafts can be really useful.
A business overdraft provides a bit of a safety net – because it doesn’t matter what industry you're in, things change. Things that might be out of your control, but that can directly impact your cash flow.
The principles of a business overdraft are the same as a personal overdraft. But there’s a lot more to consider with the former, and that’s exactly why we’ve created this guide to business overdrafts.
By the end, you’ll know how they work, the fees associated with them, the advantages and disadvantages, and the alternative finance options available. That way, you’ll be able to make a more informed decision about whether having a business account with an overdraft is right for you.
If your business account has an overdraft facility, you can access more money than the amount you have in the account. Simple, right?
This gives you greater cash flow flexibility and can be particularly useful in helping deal with emergencies and short-term funding needs, such as:
A business overdraft works by allowing you to continue to access funds even after your current account balance drops below zero.
You have to pay back the money, of course. And like a business loan or business credit card, you'll have to pay interest on the amount of credit borrowed. Once you repay the outstanding figure and your account goes back above zero, you stop paying interest.
The overdraft will have a limit, which is set by your overdraft provider – usually a bank. This limit 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 is possible to increase your overdraft limit. The bank will only do this if they believe the business can effectively pay back the additional funds 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 what's called a ‘secured’ overdraft.
With a secured business overdraft you’ll need to use a business asset (such as a commercial property you own) as security, whereas with an unsecured business overdraft you won't.
If you have a secured overdraft and can't pay it off within a certain time period, the bank could sell your asset to recoup the money you owe. In contrast, while an unsecured loan doesn't require an asset as collateral it is more likely to have a higher interest rate.
Normally, you can only get a business overdraft with the bank you have your business current account with, so that’s exactly who you need to contact. Depending on your bank, you can usually apply by going in branch, by calling or by going online.
To qualify, you’ll need to meet your bank’s eligibility criteria. This will involve them reviewing your business, and its financial history. To check you’re a reliable borrower, your personal and business credit history will also be checked.
As part of your application, you may also have to outline how you’ll use and repay your overdraft. And typically, the larger the overdraft, the more details you’ll need to supply.
If your business overdraft application is declined, don’t panic. There are other ways to finance your business to meet your funding gaps or achieve your goals.
This is where you polish your shoes and put your best suit on to visit your bank in advance to arrange an overdraft. Or stay in your jeans and trainers and call them. Either way, you’ll have an agreement in place before you spend more than the amount of money you have in your business current account.
At the meeting, where hopefully you’ll get a chocolate digestive if nothing else, is when the interest rate charge and the duration of the business overdraft is confirmed.
This is where you go overdrawn or exceed your agreed overdraft limit, without contacting your bank first.
If you had a business overdraft already in place, and you went over it, you’ll probably be charged a penalty fee and a different (usually a lot higher) interest rate on the extra money you borrowed.
If you didn’t have a business overdraft in place before going overdrawn, you’ll be charged a penalty fee and interest on the amount you went over by. Once again, this interest rate is likely to be a lot higher than the interest charged on a pre-arranged business overdraft.
In June 2019, the Financial Conduct Authority (FCA) published an article confirming there was going to be a ‘shake-up to the overdraft market’ (PDF). The BBC have also written an article on this. The new rules will come into place in April 2020 and are designed to make overdrafts simpler, fairer and easier to manage.
It follows research carried out by the FCA that found firms made over £2.4 billion in overdraft charges in 2017. Some 30% of this came from unarranged and informal overdrafts. They also discovered unarranged overdraft fees could be up to 10 times higher than payday loans.
As part of the FCA’s new rules, banks and building societies will be unable to charge more for an informal overdraft than for a formal overdraft. This is in addition to rules introduced in 2018 that required banks to set up an alert system to help people avoid unnecessary overdraft charges. This came off the back of the Competition and Markets Authority (CMA) Retail Banking Investigation.
This is great news for consumers. But these new rules don’t apply to business overdrafts. All of which begs the question, is enough being done to protect businesses from excessive overdraft fees and charges too?
Shoot for the moon with your business. Image: Jakob Owens
As mentioned earlier, banks charge interest on the amount of credit they lend on a business overdraft. These rates are typically higher than the rates charged on business loans. But interest charges aren’t the only way the banks make money.
Below are some of the additional business overdraft fees that banks charge, which you should also factor in to the overall cost before you take one out.
One to definitely look out for. Most banks don't charge this, so if yours does, certainly question it.
This is an ongoing fee that is charged by your bank for managing the overdraft.
This is something you have to pay upfront to the bank for setting up the business overdraft facility for you.
Exceed your overdraft credit limit and you’ll be hit with a penalty charge. You’ll also probably have to pay an increased interest rate charge on the money that went over your limit.
A one-off fee charged every year. This could be a flat rate or a percentage of your agreed overdraft limit.
Charged if you want to change your business overdraft limit.
There’s no avoiding the charges and fees that come with business overdrafts, but there are a few things you can do to keep them to a minimum.
It might sound obvious, but watching your balance and planning ahead (as well as you can) can help reduce the amount you borrow. And the charges and fees you pay.
If you’re struggling to manage your business overdraft, arrange a meeting or call your bank. See if they can waive certain fees or reduce the interest rate. If you don’t ask, you don’t get.
If you have other debts, write them all down, including interest charges and fees. If your business overdraft is the most expensive, see if you can make minimum payments on other debts to focus incoming cash on your overdraft.
Ultimately, a business overdraft gives you greater cash flow flexibility. But that’s not all. There are other plus points, depending on the type of business you own, and its financial position.
A business overdraft might give you more cash flow flexibility, but it’s not all a bed of roses.
Patisserie Valerie is a good example of when using business overdrafts can go wrong. The café chain went into administration in January 2019, following a financial crisis in October 2018 when a ‘£40m black hole’ in its finances was discovered.
According to The Sunday Times, nearly £10 million of this was as a result of two ‘secret’ overdrafts with HSBC and Barclays. Now, these overdrafts weren’t the sole reason for the company’s financial problems, but they won’t have helped.
Keep your business flying high. Image: Dose Media
Being rejected for a business overdraft by your bank can be rather annoying. Especially if you’ve been a loyal customer.
There’s also the possibility that an overdraft isn’t the right path for your business, particularly if you’re looking for a more long-term funding solution.
There are plenty of alternatives for you to consider. Some of which are more complex than others. And as with business overdrafts, each one has its advantages and disadvantages.
The Government has a long list of ways you can finance and get support for your business. Here’s a more digestible overview. Just ensure you look into these in more detail before you make a decision.
Probably the most obvious form of finance for a business. And at the risk of teaching granny how to suck eggs, you receive a lump sum of cash from a lender, and then repay them (with interest) over an agreed time period.
The interest rate can be fixed or variable, and similar to business overdrafts, they can be secured or unsecured.
Although there are plenty of companies now offering business loans, as well as traditional banks, be aware they aren’t all the same. At iwoca, we like keep things simple – and fast. You can apply in minutes, and could potentially receive the money in hours.
Another popular way to manage cash flow. A business credit card has similarities to a business overdraft in that you’ll have a pre-arranged credit limit, an interest rate and a number of fees. Some business credit cards also offer rewards schemes, where you can collect points to redeem against travel or retail perks.
To raise funds, you sell invoices owed to you to a third party at a discount (typically 2% to 6%). They then control the sales ledger and collect the debts. The third party (the factor) pays you about 75% of the face value immediately, then the remaining amount (less the discount) when your customer pays.
This is similar to ‘factoring’ in that you receive funding from a finance company based on invoices owed to you. However, you remain in control of the sales ledger and collect the payments yourself.
It allows you to receive cash almost as soon as the invoice is issued, rather than waiting for the normal credit terms. Albeit at a reduced amount once the finance company has taken their cut.
Historically given to businesses whose revenue primarily comes from debit and credit cards, like restaurants and shops. If that sounds like you, you can get a lump sum of cash upfront, in exchange for a percentage of your future sales.
If you’ve got assets like vans and machinery in your business that have been paid down, you could consider leasing them back. That way, they stay in your business, but free up cash to use elsewhere.
To secure business finance, you can use equity in your home or commercial premises. But it can be a rather complicated way of getting additional funds.
Peer-to-peer lending and crowdfunding has grown in popularity in recent years. It allows you to borrow money or sell equity to one or more individuals (rather than a traditional financial institution) using an online platform.
Trade finance is typically used by businesses that import or export goods. For example, when an exporter needs the importer to pre-pay for goods before they are shipped. So, the importer’s bank steps in by providing a letter of credit.
A bank may also loan money to an exporter on the basis of an export contract.
Every business has different circumstances, so an overdraft shouldn’t automatically be the go-to option for securing extra funds.
Hopefully you’ll now have a far greater understanding of business overdrafts. So much so, you’ll be able to decide if requesting one from your bank, or using a different source of funding, is right for your business.
Download our free guide for start-ups and small companies looking for finance to help them grow. It covers the different types of finance, examines their pros and cons, and includes some useful tips.Send me the guide
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