Overdraft Usage and Cost-SMEs

Overdraft is a type of bank borrowing that allows the beneficiary to withdraw more than she/he has. Overdraft therefore throws the balance of the account in question into 'red' or negative. Basically there are two types of overdrafts namely regular and irregular. Regular overdraft is where a limit has been approved for a period normally one year and subject to annual renewals. Irregular overdraft is the occurrence of an overdrawn balance without any approved limit. The emphasis of this post is on regular overdrafts. Overdrafts are payable on demand however they can be run into the foreseeable future.

Overdraft is a cheaper source of funds to meet short term business needs but could however become expensive if not managed and utilized efficiently. They are mostly used to support working capital requirements in business. Managing an overdraft effectively begins with utilizing it for the right reasons. The moment an overdraft is utilized for the purpose of meeting long term business needs such as assets acquisition, there is trouble from day one. I will explain why such an arrangement would spell doom for the beneficiary in terms of the cost of funds.

An understanding of how overdraft operates is key to managing it effectively. There is always an approved maximum limit of an overdraft a business can operate. This means, the business is allowed to overdraw its account to the tune of the approved limit. When the limit therefore is exhausted, no further withdrawals are allowed until the business pays down. A pay-down on the account naturally creates room (thus the difference between the account balance and the approved limit) for the beneficiary business to withdraw on the account again. This cycle of withdrawals and pay-downs would continue up to the expiry of the facility mostly within twelve months.

Overdrafts come at the a cost and this normally is spelt out in the offer letter that the customer accepts. There are normally conditions precedent in the offer to the customer but that is not the subject for discussions and so would shelf it for now. The cost is stated at an agreed interest rate which the bank calculates it on the overdrawn balance on daily basis but applies it monthly. The eye opener for any customer is to understand how overdrafts are calculated so an effective management strategy could be deployed. Interest is calculated daily on the outstanding overdrawn balance after all daily pay downs, therefore the higher the overdrawn balance in a day, the higher the accrued interest. Businesses with good overdraft account conduct do not utilize overdrafts if there is no need for it. However, an overly low utilization rate may mean to the bank an over-estimated overdraft need.

Here lies the trick to running a cheaper overdraft. If the overdraft was invested in working capital say in stock, that is for the right reason, then every sales must reflect on the account until the next needed purchases to replenish the stock. That means, the business ought not keep a dime with it except for petty cash; such a strategy would throw the account into 'blue' (credit) at certain point. Any time the account goes into 'blue', no interest would be paid on the overdraft. In certain banks like ADB Ghana Plc, the business could enjoy interest paid to it from the bank for certain credit balances even though the account has an overdraft limit. It is practically possible to run an overdraft account to pay an effective interest rate which is very low of say 5% for an approved rate of 20%. Effective interest rate is the interest rate that the business actually pays due to the way the account is run whilst the approved rate is the rate agreed for the establishment of the overdraft or rate to be applied. I always say that, even though the overdraft has a quoted rate, what you actually pay depends on you. The effective rate is therefore determined by the customer.

Due to the way overdraft works, any attempt to deviate from how it should be run is disastrous. Businesses mostly SMEs do fall for the temptation of using cash from sales to turn around another product when they run an overdraft; instead of paying daily sales into account, they would be keeping the cash and would try another product and only attempt to pay down on the overdraft when the month is about to end. This strategy is not only risky but expensive for overdrafts as it has the tendency to create what is known in banking circles as hardcore. Hardcore is a situation where the overdrawn balance does not come down or comes down a little in a month and recurs throughout the tenure of the facility or until it reaches expiry. A hardcore phenomenon causes the account to behave like loans and unlike loans a typical neck-to-neck hardcore would create a cumulative effect in terms of interest application. This is because, in the absence of any pay-downs, interest for a particular month would add on to the overdraft balance and would become the new base for subsequent calculations and the cycle continues month by month.

Hardcore situations are primarily driven by business entities. As I said in the early paragraphs, the purpose of an overdraft is very important if a business is to get the most from it. It must be used for short term needs of the business say invest in stock, pay salaries, pay tax, pay creditors etc. However, some businesses use overdraft to finance long term business needs which take a longtime to recoup or bring back cash into the business; such tendencies lead to high cost of overdrafts and may affect the credit worthiness of the business entity involved. In my experience as a relationship manager, I have come across business owners who used overdrafts to roof their private residential buildings, some acquired cars and some machinery. These long term needs are better financed by term loans.

To cure the hardcore on account, the bank would term out the hardcore portion of the overdraft as a loan facility and spread it over a period that is comfortable for the cash flow of the business involved. It also calls for behavioral change from the operators of the account as being advocated for in this piece of writing to cure hardcore on account. All daily cash sales must be lodged into account. Account managers must also monitor account if possible daily to track customer's sales to detect early diversion of funds. Cash withdrawals on account must be discouraged in favor of cheque withdrawals where customer's penchant for cash spending is high and these cheques must be traced to known business suppliers who serve the purpose of the overdraft. The bank may consider a bank guarantee as a substitute to the overdraft if there is high chance of diversion from the customer involved and where customer trades 80% of business with a supplier.

It is therefore not in the interest of any business entity running an overdraft to be keeping cash with it or be building cash from sales into a different account or misapply the overdraft in terms of usage. No matter how high an account would be yielding interest in another bank, it can not yield more than your overdraft interest and therefore the thinking that the business could earn some interest somewhere before paying down on the overdraft account does not suffice. Let me dispel the notion that the bank may block payment when the business sends all cash to the bank. Businesses hold this view when the facility is about to expire. In such instances, my advice is that always make an early application to the bank for renewal and submit all required documentation on time. The bank would not just block your overdraft when you are in business and running the overdraft efficiently while there is a pending application for renewal. In such circumstances, the bank grants an extension pending the approval of the annual review.

In both Covid-19 and post Covid-19 era, businesses must pay less on usage of funds this could be achieved not only from a reduction of interest rates from banks but an adoption of right cash management practices. This thinking informed this article to enable businesses pay less on usage of overdraft funds which has implication for business profitability and credit worthiness. Businesses especially SMEs must ensure that their sales reach the bank on a daily basis whether they have overdraft or not and in the case where there is an overdraft, such a strategy would ensure lower cost of funds aside risk benefits of daily lodgments. For SMEs, their daily sales could reach the bank through direct lodgments, mobile money uploads and payments to bank's agents.