One of the biggest challenges for borrowers is understanding what credit structure his business requires from the bank, they are often confused about whether what they require is a Term Loan or a Bank Overdraft. To some, once they need bank funding for their business what they need is Overdraft while for some it’s a Term Loan.
I have also come across bank credits badly structured either as Term Loan or Overdraft. This article looks at the meaning of Overdraft, when you need them and why it is the best for your business at a period.
What is Bank Overdraft?
An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. In this situation the account is said to be “overdrawn”. If there is a prior agreement with the account provider for an overdraft, and the amount overdrawn is within the authorized overdraft limit, then interest is normally charged at the agreed rate. If the negative balance exceeds the agreed terms, then additional fees may be charged, and higher interest rates may apply. – Wikipedia
A Bank Overdraft sometimes refer to as Working Capital Finance, Stock Replacement Facility or Key Distributorship Finance. Or in some cases salary advance allows you to draw your account beyond what you have in your bank balance.
In other words, it allows your account goes below zero. It allows you to use the bank’s fund and return it all at a specified period often time within a month, 45 days or 60 days depending on your business or personal financial needs.
Overdraft is revolving, which means you can also take it after you have returned the money and use it again. The tenure is often within 1 year and the limit (Sanction Limit) the bank has given you can be renewed, enhanced to a higher limit or even reduced if you have not utilized the limit effectively at the time it expired.
Overdraft is structured in such a way that interest is charged only on the bank funds that have been used. If the negative balance exceeds the agreed terms, then additional fees may be charged, and higher interest rates may apply. Administrative charges are however taken upfront before the approved limit is set on you account.
Why Bank Overdraft?
You need overdraft if you are a trader, you Imports and distributes imported product, you are a distributor to a local or foreign producer of consumer goods.
An overdraft is meant to enhance your working capital or cash flow. It is supposed to be allow you stock goods and sell within days and bring the money back into your account and use again to stock goods.
Overdraft can also be used to fund payment of workers salaries pending when you will have your sales proceeds credited into your account.
Overdraft is not a credit availed to buy property, equipment or machines or “marry a new wife” it is not to be used to fund capital expenditures. It is strictly to be used to fund daily cash flow short gaps.
When do you need Bank Overdraft?
- You need an overdraft when you have need to stock goods in anticipation of a favourable increase in sales price in the nearest future or in a period of anticipating an unfavourable increase in cost price in a short period.
- You need overdraft in period on inflation/recession when the cost of your sales has gone up and your current working capital cannot adequately fund your stock level.
- You need overdraft in the period of expansion. The period when you have identified new market/s for your business, and you need to increase your stocks to meet up with the new demands.
- When you are starting a new business/production line and you have invested in plant and machinery and you have needed a facility to fund the purchase of raw materials and pay workers.
- When sales proceeds and purchases result in a flow of money in and out many times during a month. You need an overdraft due to the timing mismatch.
- Overdraft Facility have however been subject to abuse by customers who most times draw from the overdraft limit to invest in capital projects. This automatically make the overdraft sticky with the accounts remaining in debit for a long time.
Most banks have however been able to change the structure of Overdraft and have different variants proposed to customers, some of the new variants includes: Stock Replacement Facilities (SRF), Import Finance Facility (IFF), Key Distributor Finance (KDF) and more. The essence of these change is to be able to monitor the utilization of the limit availed to customers.