An overdraft is a facility that can be part of the current account of a business.
Business overdraft borrowing takes place when the business makes payments out of its current account and exceeds its available balance.
Business overdrafts are a very common way of financing small and medium-sized enterprises (SMEs), and are ideal for those with fluctuating finance requirements. They are either provided over a fixed period of time or as a rolling facility with no end date.
Overdrafts can be authorised or unauthorised. The former is a pre-agreed facility and will be offered at a lower rate than unauthorised overdrafts. The use of unauthorised overdrafts will often incur charges for the business, so it is wise to agree an authorised facility if a need for funds is anticipated.
Overdrafts are commonly available in sterling and other major currencies. Larger facilities will often need to be secured, depending on the lender and the business’s level of risk.
Overdrafts are often used to ease pressures on working capital and as a back-up for unexpected expenditures. They are a form of finance for businesses that experience fluctuations in working capital.
There are six main direct costs that need to be considered:
Business overdrafts are normally provided at a cost, which is generally an annual arrangement or maintenance fee, plus interest on the overdrawn amount at the end of each day. Other fees and charges may be applicable, such as a non-utilisation fee, depending on the size of the facility and on the lender.
An arrangement fee is an administration charge payable to the lender to reserve the funds and to cover opening costs; this is usually a one-off fee. There are also maintenance fees or charges that cover the maintenance of the facility; this is usually a monthly cost.
Interest will vary depending on risk of default. Due to the flexible nature of overdrafts the most common type of interest rate charged will be variable (a margin over base rate or London Interbank Offered Rate [LIBOR]). A higher rate will often be charged for utilising the unauthorised facility.
Businesses exceeding their authorised facility may be charged unauthorised borrowing charges such as unpaid fees and a utilisation fee. These are often capped by banks to reduce a business’s exposure but can still add up to a significant amount.
In some instances, and more often for larger facilities, the cost of borrowing can be reduced if the overdraft is secured, as the risk to the lender will generally be lower. The security provided by the borrower can be business assets, guarantees or security, or third-party guarantees or security.
This also applies when covenants or other information are required by the lender as a condition of providing the overdraft facility and of its continued availability. Information such as current management accounts and/or cashflow projections can be requested on a regular basis, which will be agreed prior to sanctioning. Therefore, the cost associated with creating and supplying such information should to be taken into consideration before entering into an overdraft contract with a lender.
Legal fees will vary depending on if other services are provided, the complexity of the business, its size and risk to the lender. Fees are likely to apply when a personal asset, such as a jointly owned property, is provided as security.
Fees to prepare management accounts will vary depending on whether other services are provided - bookkeeping, for example - and also on the complexity of the business, its size and the frequency of issue. A business would commonly be charged between £250 and £1,000 per preparation.
The timeframe for arranging an overdraft will vary, depending on the stage of readiness of the business and the size of the facility. Unsecured overdrafts can be available immediately or in up to two weeks, whereas secured overdrafts can take between one to three months to arrange.
Timings will also depend on whether new security, new valuations or legal advice are required.
The right finance for your business section of the site gives examples of financial structures that are suitable for different trading types and sizes of business.
Business overdrafts are a common type of short-term finance. For medium to long-term borrowing needs, a bank loan may be more suitable.