How to Manage Business Overdrafts and Bank Loans
Debt finance is an effective and flexible means of financing your business – if used properly. Read on to find out how
Overdrafts and bank loans are the most common way for businesses to obtain external finance – but they have to be used properly.
While carefully managed debt finance offers a flexible and cost-effective way of investing in your business and keeping on top of cashflow, poor debt finance decisions can cause major problems and eventually failure.
How do I decide what kind of finance I need?
First of all, you need to work out what ‘gearing’ you want your business to have, meaning the proportion of your finance you have in the form of debt as opposed to investment.
To establish this you should consider your cashflow, less available cash might mean you struggle with repayment, as well as your risk profile – more risk isn’t always bad. If your investors are prepared to accept higher risk in the expectation your company will do well, a higher gearing is appropriate.
You should also establish the security you can offer lenders as you will find it difficult to obtain loan finance on good terms without assets or guarantees to secure the loans against. If your loans are likely to have a higher cost, you should go for a proportionately lower gearing and generally your debt finance should be a mix of fixed-term loans and overdraft facilities.
Loans are typically used to finance the purchase of new equipment, cover the costs of starting up, and other fixed- or long-term finance needs, while overdrafts are used to cover short-term shortfalls in cashflow and account for unexpected day-to-day business expenses.
Lastly, you should make sure you arrange all your financing to make sure you have enough. Play it safe – allow an amount for cashflow shortfalls and other unexpected occurrences.
What are the advantages and disadvantages of overdraft finance?
The main advantage of overdraft finance is its flexibility: you can dip in or out at any time and aren’t committed to long term long repayments. Another advantage is that you only pay interest or charges on the amount you are overdrawn by each day. If you manage your finances smartly, using your overdraft is often a cheaper option than taking out a loan.
The major disadvantage of an overdraft is the lack of predictability. The bank can demand repayment of your overdraft in full at any time. Additionally, you will have to regularly re-negotiate the terms of your overdraft facility with your bank – if they deem your creditworthiness to have suffered in the last period, you could see your facility reduced or even revoked.
There are also a number of extra costs on top of interest and you may have to pay setting up fees every time you take out or renew an overdraft facility. If you exceed your limit you will also be subjected to penalty fees and a much higher rate of interest, as well as non-utilisation fees if you have a larger overdraft facility, which charge you on the proportion of the overdraft you’re not actually using.
What are the advantages and disadvantages of loan finance?
Loans are much more predictable: provided you meet your payments and interest, you have a guaranteed amount of finance. Unlike an overdraft, the bank cannot suddenly demand its loan be repaid in full.
Loans also have fixed terms allowing you to match the term of a loan to your ability to repay, and potentially to the expected life of an asset. For example, you could arrange finance over 10 years to fund the purchase of laptops which will become obsolete in 10 years. You can also negotiate more flexible terms on interest rates.
Loans are not as flexible as overdrafts. You will pay interest on the outstanding loan over a longer period, and you may be required to commit to various binding agreements before taking one out.
You will also need to be secured against something, such as property. If you default on the loan, there is a chance you could lose the assets you used as security. Alternatively, if you don’t have valuable assets to secure loans against, you will find it more difficult to obtain a loan and will have to pay higher interest rates.
There are extra costs including arrangement fees, which you pay when you take a loan out – normally calculated as a percentage of the total loan – as well as pre-payment fees, which apply if you want to pay back the loan early. There are a variety of other charges such as taking out insurance and other costs incurred such as the valuation of assets.
How can I minimise the costs of debt finance?
Work on your credit score. The better your credit score, the better rates you can obtain on loans and overdrafts. Your credit score is generally assessed based on factors such as: The assets you can provide as security, your business’ general financial performance, how low your existing gearing is, how credible your business plan is, how reliable you have been with loans and overdrafts in the past and your cashflow projections.
Ask for the total cost of debt finance. In the case of a loan, ask the bank how much the financing will cost you in total, taking interest payments and charges into account. You can use these figures to directly compare providers.
Shop around for quotes. The process of being approved for debt finance can be a long one, so it is best to target just a few providers and play them against each other to negotiate better rates.
Make friends with your bank manager. A strong relationship with your bank will increase your chances of obtaining finance in the future.
What security will the bank want for loans or overdrafts?
Your bank will want to secure a charge over some of your assets before it can grant you finance, which it can seize and sell if you default on repayment.
As security you could offer:
Fixed charges over assets. This is the most common way of financing a loan. Fixed charges are usually over a property, vehicles, or other concrete assets that belong to you or your business. Banks will usually lend you 50-80% of the value of your assets.
Floating charges over assets. Floating charges are secured over company assets that are constantly changing or less tangible, like stock that is constantly sold on or replaced, customer goodwill and work in progress.
Invoice finance. Some banks will loan you money using your unpaid invoices as security, typically to around 60% of their value. You could also use one of a growing number of specialist invoice finance companies.
Personal guarantees. If you are a director of a limited company, you may be asked to provide a personal guarantee – this essentially requires you to commit your personal assets as security for a loan. It is an extremely risky guarantee to make – if the business fails, the bank will come after your personal assets, leading to financial ruin. If a personal guarantee is the only security you can offer, ask to limit its scope to a certain amount of money or time (for example, releasing you from the guarantee when revenues reach a set target).