One of the biggest challenges for borrowers is understanding what credit structure their business requires from the bank. They are often confused about whether what they need is a Term Loan or an Overdraft. For some, once they need bank funding for their business what they need is an Overdraft while for others it is a Loan.
I have also come across bank workers or relationship officers in banks who structures customer loan request wrongly as Overdrafts or Term Loans. 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 an 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An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero.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 (bank) 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
Furthermore, an Overdraft which is also a type of bank loan, allows you to borrow money through your current account with the bank by taking out more money than you have in the account. If your overdrawn account is a result of a formal bank approval, then the Overdraft is tagged “Authorized Overdraft” and will attract normal interest based on the approvals that you have. Otherwise, if the account is overdrawn as a result of bank charges, loan repayment, or other reasons not formally approved. The overdrawn account becomes an” Unauthorized Overdraft” and will attract penal charges and will also continue to grow in debit until it is regularized.
An Overdraft sometimes refer to as Working Capital Finance, Stock Replacement Facility, Key Distributorship Finance, or any other nomenclature for businesses and in some cases Salary Advance for individual salary earners 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 (called clean up cycle) often time within a month, 45 days, or 60 days depending on your business or personal financial needs.
Approved Overdrafts are revolving, which means you can also take the money back for your use after you have returned it and use it again and again within the tenor of the Ovedraft. The tenure is often within 1 year and the limit (Sanction Limit) the bank has given you can be renewed at the discretion of the bank, Depending on your need, your overdraft can be enhanced to a higher limit or even reduced if you have not utilized the limit effectively during the approved tenor.
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 just like that of the unauthorized overdraft and higher interest rates may apply. Administrative charges are however taken upfront before the approved limit is set on your account.
Why Overdraft?
You need an overdraft if you are a trader, you Imports and distributes imported or locally made product, and 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 allow you to stock goods and sells within days and bring the money back into your account and use it again to stock goods. An overdraft can also be used to fund payment of workers’ salaries pending when you will have your sales proceeds credited into your account to clean out the debit.
Overdrafts are not credits 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 an overdraft?
- You need an overdraft when you need to stock goods in the course of trading activity or in anticipation of a favorable increase in sales price in the nearest future or in a period of anticipating an unfavorable increase in cost price in a short period.
- You need an overdraft in periods of inflation/recession when the cost of your sales has gone up and your current working capital cannot adequately fund your stock level.
- You need an 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 need 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 Facilities have however been subject to abuse by customers who most times draw from the overdraft limit to invest in capital projects. This automatically makes the overdraft sticky with the accounts remaining in debt for a long period of time.
Most banks has 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.
