Overdrafts and Bank Loans

1. The Right Finance

1.1 Decide what gearing you want (what proportion of your financing you want to be in the form of debt). This will depend on:

• What your cost of capital is and what returns your business expects to achieve.
• How much cashflow you generate.Your debts will spiral out of control unless you generate the cash to pay the interest and repayments on loans and overdrafts.
• How risky your business is. High gearing is less appropriate if you cannot confidently predict future cashflow.
• What financial risk profile you want. If you (and other investors in your business) are prepared to accept higher risk in the expectation of higher returns, you will want higher gearing.
• How much security you can offer lenders.The amount of debt banks are preparedto offer you, and the interest rates they charge, will partly depend on how well secured the debt is (see 5).

1.2 Establish the most appropriate mix between overdraft facility and loans according to the 'matching principle'.

• Use an overdraft facility to finance cashflow fluctuations and to provide contingency financing. For example, to cover seasonal troughs in cashflow, long payment delays and to cope with sudden cashflow demands.
• Use loans to provide fixed-term financing. For example, to cover development and start-up losses, to buy fixed assets such as plant and equipment, and to fund the fixed portion of your working capital requirements.

1.3 Make sure you have enough finance.

Arrange all your financing at once and allow for unexpected cashflow shortfalls. Do not try to manage with less than you need in return for a lower interest rate.

• If you arrange too small an overdraft facility, and then exceed your overdraft limit, you will pay additional bank charges and higher interest rates. The bank may also bounce your cheques, damaging your credit with suppliers and leaving you short of working capital.
• If you run short of cash and then fail to make a payment on a loan, you will be technically 'in default'. The bank may let you miss a payment, but may impose higher costs. Alternatively, the bank may call in the loan and security.