Business overdrafts – all you need to know

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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.

What is a business overdraft?

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:

• Settling invoices you owe
• Covering overdue invoices owed to you
• Buying stock
• Paying for unforeseen expenses
• Managing supply chain issues

How does a business overdraft work?

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.

Advantages of a business 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.

• Business overdrafts are particularly helpful to seasonal businesses to cover short-term cash flow shortages.
• You only have to pay interest on the overdraft funds you withdraw.
• You can stop the business overdraft facility at any time, for example, once your cash flow is more stable.
• If you’re able to pay back the overdraft sooner, there’s normally no fee for doing so.
• Pretty quick to arrange as your bank should be familiar with your business finances.

Disadvantages of a business overdraft

A business overdraft might give you more cash flow flexibility, but it’s not all a bed of roses.

• If it’s a ‘secured’ business overdraft, you’ll have to provide certain business assets as security, in case you’re unable to repay it.
• Most business overdrafts are arranged with the bank where your current account is. Meaning you’re unable to shop around for the best deals, like you can with a business loan. Unless you switch your current account to another bank.
• The interest rate charged is often variable, which can make it difficult for you to accurately calculate your borrowing costs.
• If you go over your business overdraft limit, you can incur pretty sizeable fees and interest rate charges.
• A breach of terms and conditions, or if you’re not utilising the facility, could lead to the bank closing it down with very little notice.
• Your bank can ask for repayment of the overdraft amount at any time. This is unlikely to happen, providing you don’t get into financial difficulty.
• If you want to extend your overdraft limit, you’ll probably be charged a ‘change fee’.

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

Business overdraft alternatives

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.

Business loan

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.

Here at iwoca we offer the govenment back CBILS loan with which you can lend interest free for a year and borrow up to £350,000 over 5 years. Use our business loan calculator to find out what a loan with iwoca could look like.

Business credit cards

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.

Factoring

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.

Invoice discounting

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.

Merchant Cash Advances (MCA)

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.

Asset finance

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.

Property finance

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

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

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.

Is a business overdraft right for you?

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.

You might also enjoy reading up on:

• Building loans and construction finance
• Pub finance
• What is a bridge loan
• Difference between a secured and an unsecured loan
• Personal guarantee
• Agricultural finance
• Small business finance
• Small business loans
• Trade finance
• Start-up funding options
• Construction finance
• Forfaiting
• Savings accounts
• Commercial mortgage
• Debentures