Why do 80% of businesses fail in the first 5 years? Is it a lack of drive? Not enough hours being put into the business? Well, according to Forbes there are five reasons why businesses fail. The first three involve marketing. The fourth speaks to leadership skills and the final, fifth reason, is because a profitable financial system and business model hasn’t been developed(1). What does any of this have to do with the subject of overdrafts? An overdraft has it’s place in financial systems and models of operating and has worked for many businesses and continue to do so. In this paper we will discuss why businesses use them, what situations they are used in, and the benefits of having one in a business.
Big. Small. It’s all the same.
It doesn’t matter what size a business is before they consider an overdraft fund. At One Week At A Time we have advised many clients to investigate them because it’s key benefit is very simple: if the business hasn’t the cash available to buy goods, services, or pay essential bills, an overdraft set up to fund those purchases until the cash starts flowing again(2).
Banks are unlikely to lend funds to a business with little or no cash flow at the time of the application. Overdrafts are negotiated with the bank directly (i.e. terms, amounts, interest rates, repayments etc), based on the performance of the business and its cash flow seasonality.
Large businesses have a record of the fluctuations and patterns in their business and commonly use overdrafts as part of their financial management system. Smaller businesses may not have as large an operation, but the game still remains the same, which is why overdrafts are widely used there too. Both sized businesses are doing the exactly the same thing when they use an overdraft - they are covering their bases for the upturns and the downturns of their cash flow.
Short-term working capital. That’s it.
What is an overdraft in 3 words? Short Term Capital. In longer words - it’s a stop-gap for specific times in a business’ life and when the funds are accessed by the business, the lender requires regular repayments.
When times are good. And not so good.
The most common time when an overdraft is used is when the business is expanding at a rate of knots. Contrary to belief, overdrafts are used when times are good in a business. More projects and customers are flying in the door and the business needs to quickly buy more equipment, materials or employ more staff faster than the current inflows of cash.
For example when a major contract is signed and it may represents thousands or even hundreds of thousands dollars, the current operating capital may not be enough to cover the cost to meet the contract’s needs. Overdrafts are used to get the project up and running until the first installment of the project’s major invoice is paid (and subsequently the overdraft is paid).
Overdraft funds are also be used in times when the business is slowing down and it’s in a tight position. When invoices are yet to be paid and a slower turn in customers may have happened for the month and there are basics that need to be covered. The critical piece of information when using overdrafts in the downturns is that the business needs to have a high level of certainty that the orders, customers or projects will pick up again. That way the repayments from the overdraft won’t be a problem.
An exercise in reduction.
Keeping a business in the black means reducing all the factors that may slow the business down from continuing doing what it’s doing. Learning fund management tools and finding how to manage cash flow and business operations reduces risk in a business. Robert T. Kiyosaki summed it up best in his book Cashflow Quadrant when he said, “Having financial vision lowers your risk. Being financially blind increases risk... to be successful….you must think in numbers…..understanding financial numbers and systems is crucial”(3). That’s why so many business leaders don’t believe overdrafts are a dirty work - they believe that overdrafts are a tool that’s always ready for them to use, as part of their business’ overall financial armoury.
References
(1) https://www.forbes.com/sites/ericwagner/2013/09/12/five-reasons-8-out-of-10-businesses-fail/#759bc96e6978
(2) http://dnbsmallbusiness.com.au/Essentials/Managing_an_overdraft/indexdl_5617.aspx
(3) Kiyosaki, R. T. (1998). Rich Dad’s Cashflow Quadrant: Rich Dad’s Guide to Financial Freedom TechPress Inc. Arizona. USA. pp 132-133
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