What is “Overdraft”? It is a type of revolving credit extended to businesses and individuals to provide working capital. It allows you to withdraw funds (up to an agreed amount) from a checking account, even when the balance of the account is zero. In other words, an overdraft allows a business to spend more money than it has in its account at a given time. Overdrafts are frequently used by businesses to manage cash flow and cover unexpected expenses that arise. For many small business, overdraft often become the most complex financing option to understand [and analyze] among the other. On the other hand, often, banks are not “so transfarent” on the fee [charges] area. This is a perfectly-bad complexity mixed on the option.
This post discusses “Overdraft“ funding option. It comes with essential overdraft funding FAQ, its advantages and disadvantages for the business owners, analyzing the use of overdraft financing with a case example. Sure it is by no meant comprehensive, but it is a good start. Enjoy!
Is An Overdraft An Effective Form of Finance for My Business?
Overdraft facilities are an effective means of short-term financing for businesses that are in good financial health but experience occasional cash flow problems, such as businesses that operate on a seasonal basis. Overdrafts are also be used to provide capital between the time a business’ bills are due and the time the business’ customer accounts are paid.
Overdrafts are not an effective form of finance for asset purchases.
Note: In my experience, if a business frequently must rely on overdraft to maintain liquidity, this may be a warning sign of a bigger cash flow problem that should be addressed promptly. And the business should start think of other type of funding [a longer term].
Advantages and Disadvantages of An Overdraft Facility for Business Owners
Advantages of an overdraft facility for business owners:
- Flexible credit options
- Ability to manage seasonal or irregular cash flow
- Pay interest only on the funds currently extended
- No fee on merchant summaries
- Prevents businesses from incurring bounced check fees
- Overdraft financing is easy to secure and provides instant financing when the business’ funds are tight.
Disadvantages of an overdraft facility for business owners:
- Higher interest rates than business loans
- Can conceal bigger cash flow and liquidity issues
- Overdrafts have a set limit, and businesses who spend beyond that limit can face hefty fines and even higher interest rates
Overdraft Funding Essential FAQ
- Does overdraft need collateral? Yes, overdrafts are frequently secured by business or personal assets. If the business is unable to bring the overdraft current through payments, the collateral can be seized. The entire overdraft amount can be recalled by the bank at any time if the overdraft terms or conditions are broken.
- Does overdraft have limits? Most lenders will set a maximum amount by which the account can be overdrawn, also known as an overdraft limit. Exceeding this limit can result in steep fines or fees and extremely high interest rates assessed on the amount charged over the limit.
- Are penalties assessed for repayment? No. Most overdraft facilities can be fully or partially repaid at any time without incurring a penalty or charge.
- What kind of interest rates do overdraft facilities carry? Overdraft facilities generally have variable interest rates; however, some lenders may be willing to negotiate a fixed interest rate on the overdraft facility.
Analyzing The Use Of Overdraft Facilities
The effects of overdraft financing depends upon the pattern of cash flows over time. Suppose that the net cash flow for period “t” in the account is denoted by “At“ which is the difference between the receipt “Pt“ and the payment “Et” in period “t“.
Hence, “At” can either be positive or negative. The amount of overdraft at the end of period “t” is the cumulative net cash flow “Nt” which may also be positive or negative. If “Nt” is positive, a surplus is indicated and the subsequent interest would be paid to the borrower.
Note: Most often, Nt is negative during the early time periods of a project and becomes positive in the later periods when the borrower has received payments exceeding expenses.
If the borrower uses overdraft financing and pays the interest per period on the accumulated overdraft at a borrowing rate “i” in each period, then the interest per period for the accumulated overdraft “Nt-1″ from the previous period (t-1) is:
It = i(Nt-1)
where “It” would be negative for a negative account balance “Nt-1″. For a positive account balance, the interest is:
It = h(Nt-1)
where “It” would be positive for a positive account balance
The account balance “Nt” at each period “t” is the sum of receipts “Pt“, payments “Et“, interest “It” and the account balance from the previous period “Nt-1″. Thus:
Nt = Nt-1 + It + Pt – Et
It = i(Nt-1) for a negative Nt-1; and
It = h(Nt-1) for a positive Nt-1.
The net cash flow “At = Pt – Et” is positive for a net receipt and negative for a net payment. This equation is approximate in that the interest might be earned on intermediate balances based on the pattern of payments during the period instead of at the end of a period. The account balance in each period is of interest because there will always be a maximum limit on the amount of overdraft available.
For the purpose of separating project finances with other receipts and payments in an organization, it is convenient to establish a credit account into which receipts related to the project must be deposited when they are received, and all payments related to the project will be withdrawn from this account when they are needed.
If receipts somewhat lag behind payments for a project, this credit account will have a negative balance until such time when the receipts plus accrued interests are equal to or exceed payments in the period.
When that happens, any surplus will not be deposited in the credit account, and the account is then closed with a zero balance. In that case, for negative “Nt-1″, Eq. can be expressed as:
Nt = (1+i) (Nt-1) + At
and as soon as Nt reaches a positive value or zero, the account is closed.
Use of Overdraft Financing for a Facility Example
A corporation is contemplating an investment in a facility with the following before-tax operating net cash flow (in thousands of dollars) at year ends:
Year 0 1 2 3 4 5 6 7
Cash Flow -500 110 112 114 116 118 120 238
The MARR of the corporation before tax is 10%. The corporation will finance the facility be using $200,000 from retained earnings and by borrowing the remaining $300,000 through an overdraft credit account which charges 14% interest for borrowing.
Is this proposed project including financing costs worthwhile?
The results of the analysis of this project is shown in the next table as follows:
N0 = -500 + 200 = -300
N1 = (1.14)(-300) + 110 = -232
N2 = (1.14)(-232) + 112 = -152.48
N3 = (1.14)(-152.48) + 114 = -59.827
N4 = (1.14)(-59.827) +116 = +47.797
Evaluation of Facility Financing Using Overdraft (in $ thousands)
Since N4 is positive, it is revised to exclude the net receipt of 116 for this period. Then, the “revised value” for the last balance is:
N4 = N4 – 116 = – 68.203
The financial cash flow At resulting from using overdrafts and making repayments from project receipts will be:
A0 = – N0 = 300
A1 = – A1 = -110
A2 = – A2 = -112
A3 = – A3 = -114
A4 = N4 – A4 = – 68.203
The adjusted net present value of the combined cash flow discounted at 15% is $27,679 as shown in the table.
Hence, the project including the financing charges is worthwhile
Overdraft Loan Facts and Statistic
- An overdraft fee of $34 for a $3.40 cup of coffee translates into a 1,000% annual percentage rate (APR) if you repay the loan in one year. If you repay the loan in one week, the APR is a staggering 52,143%!
- Overdraft loans cost consumers $17.5 billion per year, more than the $15.8 billion extended in funds to cover the overdrafts.
- A small group of consumers is paying the majority of fees. Sixteen percent of overdraft loan users account for 71% of overdraft loan fees.
- Americans who depend heavily on Social Security income pay nearly $1 billion per year in fees for unauthorized overdrafts.
- Some banks advertise overdraft loans as a way to make it until the next payday.