Don’t bother with an overdraft…an underdraft is much better

Have you ever logged in to your online banking and experienced the sinking feeling when you realise that an important direct debit has bounced?

While good cashflow housekeeping practices should prevent this from happening, sometimes something somewhere slips through, a cheque lodgement doesn’t clear on time, the overtime bill was higher than expected, or an irregular payment hits the account.

The fall-out from missing a direct debit payment can vary – but it’s never good. Those referral charges on your account can go against you if you’re looking for a loan.

I’ve seen many people in business enter an overdraft agreement with their bank to try and prevent missed direct debit payments from happening. The idea is that it creates a “cushion” or “buffer” zone, so that if the account balance runs too low the overdraft will be there to make up any shortfall.

Sounds reasonable doesn’t it?

On the face of it, it does seem reasonable. But if we consider what an overdraft is actually for, and what happens over time with an overdraft, it doesn’t seem like such a good idea.

So, what is an overdraft for?

On overdraft is a short-term finance facility. Its purpose therefore is to plug a short-term gap in cashflow. A good example of when an overdraft is suitable, is a seasonal business that has large peaks and troughs in its sales. Just before a peak that business needs to invest in stock (short-term asset), as it’s just coming out of its quiet period (trough) its cash reserves will be low and therefore insufficient to fund the stock purchases required for the busy period.

This is where an overdraft is useful. It is a very short-term loan, used to invest in a short-term asset that can be quickly sold to repay the overdraft and replenish cash reserves.

But what can go wrong by using an overdraft as a buffer…if you don’t need it just don’t use it?

If you’re disciplined and cashflow is strong then perhaps. But if you’re not disciplined and cashflow is challenged then no. In my experience what usually happens in this scenario is this:

The overdraft limit becomes the new zero

What tends to happen is that the business owner sub-consciously re-sets “zero” to the overdraft limit and operates on the basis that the overdraft limit is the new absolute bottom. When that happens, you’re back to square one as described in the opening paragraphs. The solution – EXTEND THE OVERDRAFT!!

 

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What is the solution?

Obviously, the solution isn’t to extend the overdraft – that’s when you find yourself in the overdraft trap. The best solution is not to takeout an overdraft for this scenario in the first place. In addition to strengthening your cash controls, try setting an “underdraft” limit. Obviously, there’s no such thing, but the idea is to set a lower limit for your bank balance (other than zero).

Why choose zero as some arbitrary figure below which your bank balance can’t drop?

Instead of setting the bottom at zero, choose another arbitrary figure and don’t let your bank balance go below that. What you set it at will be determined by various things including how much activity there is in the account, the value of your largest direct debit, and of course how much free cashflow you have.

Once you decide your underdraft limit be ruthless with yourself and never intentionally go below it.

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