Regardless of its size, a business can experience fluctuations in its cash flow that can make it difficult to finance day-to-day operations. Efficient cash management is one of the keys to financial security, and there are a number of tools that can be used to avoid excessive stress and bridge a cash flow gap, such as an overdraft facility. Let's take a look at the basics of this simple concept, which can be a great help when you need to act quickly.
What is an overdraft facility?
An overdraft facility is a temporary or permanent banking arrangement that provides a company with additional short-term liquidity. What is an overdraft facility? By debiting its current account in excess of the available balance for a one-off cash requirement. It bridges the gap between the company's expected income and the payments it has to make in the short term.
Also called Cashflow facility or credit facility, Overdraft facilities should not be confused with authorised overdrafts. An overdraft facility is a one-off facility that can be used once the account has been overdrawn. It is therefore more like a cash advance granted by the bank to meet a specific and urgent need, and can be used in full or in part.
In practical terms, an overdraft facility operates as a kind of very short-term credit (revolving or otherwise). It enables the company to deal with cash flow shortfalls, typically the time lag between payment of suppliers and receipt of sales revenue. This tool is used in exceptional cases, although other options may be considered if the shortfall is permanent.
Overdraft facility vs authorised overdraft: don't get confused!
While both schemes are used to meet short-term cash requirements, they are nevertheless distinguished by 4 criteria:
- Duration: the authorised overdraft is permanent, or at least intended for the medium term, and there is no time limit on its use.
- Theamount of theoverdraft facility is generally less than that of an authorised overdraft.
- The interest rate on an overdraft facility is generally more expensive than an authorised overdraft.
- The Use: the overdraft facility is by its very nature adapted to occasional and unforeseen needs, whereas the authorised overdraft meets a more permanent cash flow requirement.
Why apply for an overdraft facility?
In addition to the obvious reason of having a back-up solution in case of cash shortages, companies have other reasons for applying for an overdraft facility:
- Benefit from great flexibility and unfailing responsiveness in a business environment where cash flow can be volatile. There's no need to take urgent action when a financial need arises: all you have to do is activate the mechanism, with consequences that are known, accepted and planned for in the company's financial plan.
- Prevent payment incidents, with the certainty that a cash shortfall can be made good: no bounced cheques, no unpaid invoices, the company's reputation is safe and there are no additional costs to worry about.
- Improve the relationship of trust with your bank, by demonstrating an ability to manage cash flow proactively, which can make it easier to obtain future financing.
- Faster access to funds, which is not generally available with other forms of credit.
How does this financial tool work?
Setting up an overdraft facility requires prior agreement between the company and its bank. It goes without saying that to obtain such an advantage, you need to show your credentials: a healthy financial situation, the absence of credit incidents, and even clear prospects for development.
Once the bank has been convinced, the agreement is formalised in a contract setting out the maximum amount of the facility granted, the conditions for its use, the maximum period for which the account may remain in debit and the interest rate applicable. This avoids having to go through all the red tape every time you need a short-term loan.
In practice, several stages can be defined:
- The company sets out its needs, supported by its cash flow plan and its knowledge of periods of financial stress, and defines the financial guarantees it can call on;
- If accepted, the bank sets a ceiling on the overdraft facility, which may or may not correspond to the company's wishes, and may require that overdraft facilities be used for predefined maximum periods before returning to a credit balance;
- The contract is signed;
- The mechanism is generally activated automatically as soon as the bank account balance becomes negative;
- Reimbursement is made ;
- Interest is charged.
It's also a good idea for companies to keep a close eye on how they use their overdraft facility. Any excess, in addition to the costs and other inconveniences involved, would automatically damage the quality of the relationship with the bank.
A significant but justified cost
The flexibility of the overdraft facility explains why the interest rates offered by banks are generally higher than those for other, more conventional loans. That said, it should be pointed out that the cost applies only to the sums actually borrowed, rather than to the entire loan, the amount and duration of which could prove excessive in relation to the real need.
In addition, the bank must protect itself against the risk of not recovering what is owed if the use of the overdraft facility conceals a deteriorated financial situation that could lead to suspension of payments.
Finally, some banks may also charge an administration fee for setting up the overdraft facility, a fee for making the funds available, and a fee if the authorised limit is exceeded or repayment is late.
Overdraft facilities: modifiable and cancellable
Finally, the overdraft facility may be amended or terminated under certain conditions.
Modification of the ceiling
The company can ask to change the ceiling on its overdraft facility if its cash flow requirements change. Further negotiations then take place with the bank, which will assess the company's financial situation before giving its approval.
Change of conditions
The terms of the overdraft facility (interest rate, period of use, etc.) can also be revised, on request or at regular intervals. The bank may initiate a request for a change if its credit policy evolves, and it may be in the company's interest to renegotiate these conditions if its situation is favourable.
Cancellation
The overdraft facility can be terminated by either party. The bank may consider that the company is not complying with the agreed conditions, for example if it repeatedly exceeds the ceiling or fails to make repayments. The company, for its part, may decide that it no longer needs this service if it finds a more advantageous financing solution, or turn to another bank to obtain better terms.
In all cases, it goes without saying that the company must repay any sums obtained under the overdraft facility before being released. A notice period may also be stipulated in the contract.
In addition to the curative security provided by an overdraft facility, it is advisable to protect yourself against the risk of unpaid invoices, in particular by taking out credit insurance and carrying out a solvency check beforehand.
Contact us now to better protect your business
