Overdraft For Business Needs - Business Loan Blog - Tata Capital

When is It a Good Idea to Take an Overdraft For Business Needs?

Mar 07, 2017

Imagine if you are running just a few thousand rupees short in your business bank account. Short of what? Short of having as much money as you need to do a particular thing. It's too small an amount to borrow as a loan, and you don't want to ask your friends and family because that always gets messy.

So what do you do? You take an Overdraft.

An overdraft is a temporary facility provided by financial institutions such as Banks and NBFCs to meet short-term cash requirements. Here is Sushruth's story that will help you understand this concept better.

Sushruth started a new organic fertilizer business six months ago. Apart from the minor hiccups that every small business goes through, the company had been doing great. This was until Sushruth received a call that there was a delay in payment by a major client. This was bad news because the company had planned to pay for a new batch of raw materials with this money.

The vendor was quite particular on the payment front. A lack of payment meant that production would stop. Now Sushruth was in a fix. He did not know what to do. It would be impossible to get a business loan at such a short notice. At that moment, his accountant suggested that the company could opt for an overdraft.

They quickly contacted their bank and managed to obtain an overdraft almost immediately. This way, they managed to pay the vendor and avoid any interruptions in production.

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Overdrafts can solve short-term financial problems for small businesses. However, it is important to know when an overdraft is useful and when it can be disastrous.

Let us see when an overdraft is a good idea and when it is not:

1) Can be availed quickly
Overdrafts work great as short term loans. In fact, by utilising the overdraft facility, you can save quite some money in interest payments. This is because, unlike regular loans, the interest is calculated only on funds that are utilised.
So if you are in need of short-term funds, it may be wise to opt for an overdraft instead of a regular loan. Due to the minimal paperwork and its flexible nature, overdrafts are quite useful in emergencies. But you must ensure that the amount is incoming and that you will be able to clear it within a few days.

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2) Manage cash flows
Overdrafts come in handy for companies that have multiple cash flow cycles within a single month. In other words, if the company has many sale and purchase cycles in a month, there can be a mismatch in cash flows. For example, you may receive your payments on a monthly basis, whereas your suppliers need upfront payment (every 10-15 days). An overdraft facility can help to manage cash flow gaps in such situations.

3) Emergencies
Sometimes a company find itself in a situation wherein it has not received money for the sale of goods but it has to still pay for raw materials. Now imagine the company has no money to pay its vendor, at least until its next revenue date.
Instead of looking for credit elsewhere, the company can simply take an overdraft to pay its vendor. This way, it can manage to pay vendors even if it has zero balance in the account.

Related: How small businesses in India are financing their business needs

4) Working capital requirements: strict No-No
Many small businesses fail because they are not able to manage their working capital needs. It doesn't matter whether a company has brilliant plans five years down the line if it doesn't have the money to keep the machines running today.
Some companies wrongly assume that taking an overdraft can solve their problems. Well, it could possibly help for a day or two, but once the money dries up, it is back to square one. There is no replacement for good business sense.

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Overdrafts work great as short-term funds; but only if you are certain about repayment. Otherwise, the interest rates can eat up a big chunk of the company's income. In such situations, a working capital loan is a better option than an overdraft.

So the next time you are in a dilemma about whether to opt for an overdraft or not, keep the above tips in mind.