Return of the business overdraft

Business overdrafts have endured a tough press in recent years. But while they lack the marketability of loans and credit cards or the sexiness of invoice discounting, they remain as important as ever to growing businesses.

Many financial sages have been prophesying the demise of the business overdraft for some time. After all, they’re perceived as a bit stuffy, safe and reliable – in fact, in many ways they’re the financial equivalent to a mug of cocoa and an early night. But is the end really nigh for what is often dubbed the oldest financial product of them all? The short answer appears to be no.

Overdraft facilities for growing businesses on the rise

While overdrafts are hardly headline-grabbing, many in the banking industry consider them to be an essential aspect of a business’ financial requirements. There are plenty of statistics to back this up. In a recent survey of small and medium-sized firms in the UK, a team from Warwick Business School concluded that almost two million SMEs (53 per cent) still use an overdraft and are borrowing an estimated £12 billion between them through such facilities. This figure compares favourably with the 24 per cent who utilise term loans (to the tune of £64 billion), the three per cent subscribing to invoice finance (£8 billion) and the 55 per cent who use either a personal or business credit card in their line of work.

Rumours of the overdraft’s demise have been grossly exaggerated, according to Stephen Pegg of Lloyds TSB. ‘In the late 1990s loans came increasingly to the fore and invoice discounting increased in popularity too. But over the past three years overdraft balances have started to rise once more.’

Stewart Dickey, director of retail banking at the British Bankers Association (BBA), echoes this. ‘[Our figures show] that the amount of money lent to growing businesses through overdraft facilities continues to rise,’ he explains, ‘although there has been even greater growth in term lending.’

Getting a business overdraft

If you’re a business with annual turnover of £1 million or more, securing an overdraft should be a relatively straightforward affair. According to Dr Richard Roberts, chief economist at Barclays Bank, ‘what banks want to see when you apply for an overdraft is evidence from your banking history that can justify your claim. Most use a form of behavioural scoring, with points allocated for appropriate use of bank facilities, a good financial track record and good cash husbandry.’ A healthy relationship with your business banker helps as well, although Roberts says that the key question is, ‘Does your business have the free cash flow to service the repayment on an ongoing basis?’ If it does, a facility should be forthcoming. ’The amount you can borrow will be dictated by the level of free cash flow as well.’

Safety, simplicity and cost effectiveness

One of the main attractions of an overdraft, says RBS’ Steve Richards, is that it ‘provides a safety net’. To many companies, even those working almost exclusively in credit, the facility is something they like to have as a back-up.

Another asset is its simplicity and ease of use. When a business needs to buy goods or services but doesn’t have the necessary cash available at that moment, it can simply dip into the overdraft to fund the purchase.

‘An overdraft can provide instantly available funds to bridge the gap between paying suppliers and getting money from customers,’ argues Pete Ferns, director of business banking at NatWest. So, overdrafts are ideally tailored to maintaining cash flow and helping a business through minor lean spells, without resorting to full-blown invoice discounting. Moreover, points out Richards, ‘It’s more cost effective to buy goods through an overdraft than on a credit card,’ where the associated interest rates are far higher.

The other major benefit over fixed term loans is that you only pay interest on what you borrow for the appropriate period. Go £1,000 into your overdraft and then return your account to credit less than a week later and you will only pay interest on that amount for those few days. Take out a six-month loan for the same amount and far more interest will accrue.

Lastly, overdrafts are hugely flexible. Limits are agreed at the time of an account’s opening and reviewed periodically, yet the increasing popularity of telephone and online banking have made it simple to secure adjustments to your limit – if you know you are about to overstep it – within hours of your request.

Use it wisely

The downside to this potential fluidity is that overdrafts must be used sensibly and, ideally, for a specific function.

‘Mostly, the onus is on clients to ensure they have the appropriate facilities in place and to make sure limits are changed when needed,’ Abbey’s John Brooks warns. ‘Increasingly, banks treat an overdraft limit as a genuine limit, so we impress on people the importance of making sure their facilities are suitable for the purpose.

‘From a financing viewpoint, the type of finance you use should reflect what you’re using it for. Overdrafts should be restricted to short-term working capital requirements. But if you’re acquiring plant, property and the like, other things like loans, mortgages and invoice financing will be more suitable,’ he concludes.

Fortunately, it appears growing businesses are heeding these messages.

Managing the facility

The secret to managing your overdraft is thus to keep your business account dynamic.

‘The best way to use it is to move from being overdrawn to in credit on a regular basis,’ ventures Pegg. ‘If you have hardcore debt on your overdraft it would make more sense to restructure this to a long-term lending facility.’ Seasonality aside, if an account isn’t moving into credit at least once every few months, then questions clearly need to be asked.

Remember, your bank will keep an eye on things too. ‘With all our customers we monitor performance and get them to keep us in touch with how things are going,’ says Pegg.

‘The best advice is to go in and talk to your bank manager in order to work out what you need,’ adds Richards of RBS. ‘It’s important to understand that business can be unpredictable and our job is to give you the financial tools necessary to help you through.’

Rates and charges

Interest rates on overdrafts are only charged when an account is in debt but most banks will also charge an annual fee for the privilege of having a facility.

It is, however, difficult to pin down banks on precisely what these charges may be because, as Dickey explains, ‘Overdrafts are negotiable.’ The reason for this is that banking is an increasingly competitive market and, as such, banks are always eager to lure quality businesses away from their rivals using every facet available to them.

‘It’s important for us to offer competitive [overdraft] rates as that often plays a role in choosing packages [for those switching from a rival bank],’ admits Pegg. ‘We would typically offer switchers six months’ free banking and about 12 months [of special rates] on their overdraft. Increasingly, the costs are very competitive amongst lenders, though you will usually pay an arrangement fee upfront and there’s an annual fee too.’

Somewhat paradoxically, it is often the case that the more financially stable a business, the better the package  offered. It pays to manage your finances well.

For those who breach their limits, however, expect not only increased interest rates, you’ll also receive letters from your bank, which will probably charge for the privilege of writing to you!

Some banks levy a flat charge of £20 as and when a facility is exceeded by more than £100 and often bill a further £20 for each £100 exceeded thereafter. Interest on excessive borrowing, meanwhile, may be charged at a staggering 29.5 per cent per annum, emphasising just how important it is to stay inside your limits.

See also: What are the best alternatives to a business overdraft? – Conrad Ford outlines three alternative financing options to a business overdraft.

Marc Barber

Marc Barber

Marc was editor of GrowthBusiness from 2006 to 2010. He specialised in writing about entrepreneurs, private equity and venture capital, mid-market M&A, small caps and high-growth businesses.

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