A business overdraft, also called business overdraft protection, is a type of financial arrangement where a business is allowed to withdraw more money from its bank account than it currently has available. It’s a form of short-term borrowing that provides temporary access to more funds when the business experiences a cash flow shortfall or needs to cover unexpected expenses. But there are reasons you may want to avoid them.

In this article, we’ll explore everything small business owners need to know before using business overdrafts.

Understanding Overdrafts

A business overdraft is an agreement with a bank or financial institution that lets a business take out more money from its business checking account than its current balance.

Here’s how it typically works:

• Approved limit: The bank sets a predetermined limit for the business overdraft, which is the maximum amount the business can withdraw over its available funds. This limit is determined based on things like credit approval, financial history, and relationship with the bank.
• Flexible access: Once you’re approved to make overdraft transactions, you can access the additional funds over your available balance— up to the specified limit. You can make ATM withdrawals, make debit card purchases, or perform electronic transactions just like with a regular bank account. The overdrawn amount usually comes from a connected line of credit or business savings account.
• Interest and fees: The bank charges interest on the amount utilized from the overdraft facility. Interest is typically calculated daily and charged monthly. Additionally, there may be fees associated with establishing and maintaining the overdraft, such as an annual fee or transaction fees for each withdrawal.
• Repayment terms: The overdraft is a revolving form of credit, meaning the business can repay the borrowed amount and then borrow again within the set limit. The repayment terms vary, but typically businesses are required to make regular payments to reduce the outstanding balance. The bank may also require a minimum payment each month, which could be interest-only or a combination of principal and interest.

Business overdrafts can provide several benefits, like flexibility to cover unexpected expenses, pay suppliers, or manage temporary dips in revenue without disrupting your operations. Also, unlike loans, overdrafts typically don’t have fixed repayment schedules. As long as the business stays within the agreed limit, it can borrow and repay funds as needed. Plus, you’ll pay interest only on what you borrow, not on the entire overdraft limit.

However, it’s important to use business overdrafts carefully and be aware of potential drawbacks like high-interest rates, fees, and the risk of dependency.

Business Overdrafts: Why to Avoid Them

While business overdrafts can offer flexibility and provide cushion for businesses when managing their cash flow, there are several reasons why it’s generally a good idea to avoid relying on them:

1. High-interest rates: Overdrafts often come with high-interest rates and fees. The cost of borrowing through an overdraft can be significantly higher compared to other forms of financing, such as business loans or lines of credit. This can add a big financial burden to your business, especially if the overdraft is used frequently or for extended periods.
2. Lack of predictability: Overdrafts are meant to address short-term cash flow gaps, but they aren’t a sustainable solution for ongoing financial needs. Relying on overdrafts as a regular source of funding can lead to a lack of predictability in cash flow, making it difficult to plan for future expenses or investments.
3. Risk of dependence: Using an overdraft as a constant source of funds can create a cycle of dependency. It may mask underlying financial issues or poor business practices that should be addressed instead. Over time, a business can become overly reliant on overdrafts, leading to a higher risk of financial instability.
4. Limited credit availability: Overdrafts typically have a predetermined limit set by the bank. If your business reaches or exceeds this limit, you may face additional penalties or have your overdraft facility revoked. This can leave your business without a safety net for managing unexpected expenses or cash flow gaps.
5. Possible negative impact on credit rating: Consistently relying on overdrafts or exceeding the overdraft limit can negatively affect your business’s credit scores. This can make it more challenging to get good terms on future loans or credit arrangements. Maintaining a healthy credit rating is crucial for accessing more affordable financing options when needed.

It’s important to note that while avoiding overdrafts is generally a smart move, there may be situations where an overdraft can be a reasonable short-term solution. However, businesses should aim to address the underlying causes of cash flow issues and work towards establishing a more sustainable financial position over time. Consulting with a financial advisor or business banking professional can provide valuable guidance in managing cash flow and finding appropriate financing solutions.

Importance of Good Cash Flow Management

Good cash flow management is necessary for the financial health and success of any business. It refers to the process of monitoring, analyzing, and optimizing the inflow and outflow of cash within a business. Maintaining a positive cash flow helps make sure that your business has enough cash on hand to meet its immediate financial obligations, such as paying suppliers, employees, and other operating expenses. It provides stability and safeguards against financial distress or potential bankruptcy.

Effective cash flow management also allows you to plan and allocate your business resources efficiently. By understanding the timing of cash inflows and outflows, you can optimize your cash reserves, streamline operations, and make well-informed decisions about things like investments, expansion, and inventory management. It also allows you to pay off your debts on time (or early), which improves your reputation with lenders and helps maintain access to future financing options with good terms.

By implementing effective cash flow management practices, businesses can improve their financial stability, optimize operations, make informed decisions, and position themselves for sustainable growth and success. 

Monitor Your Account on a Schedule

How often you should monitor your business’s cash flow depends on a few factors, like the size of your business, the industry, and your current financial situation. As a general guideline, businesses should monitor their cash flow on a regular and consistent basis. Here are some recommendations:

• Daily monitoring: Involves checking where cash was coming from and going to during the previous day, verifying account balances, and making sure all transactions are accurately recorded. 
• Weekly analysis: Includes reviewing cash flow statements, analyzing the sources and uses of cash, and spotting any trends or patterns. 
• Monthly review: Includes analyzing cash flow statements, income statements, and balance sheets for the month. 
• Forecasting and planning: Involves projecting future cash inflows and outflows based on historical data, anticipated sales, expenses, and any known upcoming events or investments. 
• Trigger-based monitoring: Involves creating trigger points for more frequent monitoring, like if your business has a significant increase in expenses, a decline in sales, or if it’s approaching its cash flow limits.

Find a Bank That Offers Business Overdraft Protection

To find a bank that offers business overdraft protection, a simple way to research your best business checking options is to use Nav. Our trusted partners are vetted and known to provide top options for small business owners. Once you find a few good options, check to see whether they offer business overdraft services, as well as other helpful features like online banking and a mobile app. 

Then look at the eligibility criteria to enroll in business overdraft protection. Banks may have specific requirements based on things like the size of your business, credit history, and financial stability. You’ll also want to compare the terms and features of overdraft protection from the different banks. Look for details like:

• Overdraft limits
• Interest rates
• Overdraft fees
• Repayment terms

Finally, take a look at customer reviews and feedback. Other users’ experiences can give you useful insight into the quality of their services, customer support, and the standard overdraft experience.

Know the Risks and Benefits of Overdraft Protection

Create a Buffer in Your Business Checking Account

To avoid over-relying on overdrafts as a business customer, you may want to keep a buffer of cash in your bank account. Having extra cash on hand means if you have unexpected debit card transactions or bills to pay, you’ll be covered without using a business overdraft. 

Reconcile Your Bank Account Regularly

Reconciling your business bank account is essential to ensuring your business’s financial records are accurate. The process involves comparing your bank statement with your own accounting records to identify and resolve any discrepancies. You’ll also want to look at your opening and closing balances, deposits and credits, and checks and withdrawals. Be sure to fix any errors you find along the way and repeat this process monthly or quarterly. Staying on top of your business’s finances can help ease the burden of relying on business overdrafts for unexpected expenses.

Schedule Payments

Putting payments on a schedule can stop you from getting surprised when the due date comes up. You’ll be able to plan to pay your bills on time and know that the expense is coming out of your business finances. This strategy can help manage cash flow and avoid using business overdrafts.

Consider Alternative Financing Options

One way to avoid overdrafts (and their fees) is to use alternative funding options like a merchant cash advance, a business line of credit, or small business loans. Keep in mind that these two options also might charge interest and fees, but the interest rate may be lower.

Here are some of the top options on the market:

Business credit cards are another option that’s often easier to qualify for than many small business loans and can cover short-term cash flow needs. The interest rates may be lower than for a business overdraft as well.

Choose a Bank With Education and Tools on Avoiding Business Account Overdrafts

Your bank should be your partner rather than a roadblock, and it should give you the foundation for success. You never want to feel like your bank is trying to pull the wool over your eyes. So try to find a bank that you feel is giving you all the information you need to keep your fees low and profits high. Work with Nav to find the right business bank account for you quickly and easily.