When Indianapolis entrepreneur Joe Traynor launched his commercial real estate appraisal business, Traynor & Associates Inc., seven years ago, he saw no need for a formal financing plan. "Initially, I didn't worry about a line of credit because I was a one-man operation. I could skip paying myself if I had to," recalls Traynor, 49.
He did, however, take steps to protect himself from the periodic cash crunches that plague up-and-coming businesses. Traynor obtained an overdraft line of credit, which kicks in when a business makes payments that exceed the available cash balance in an account. "There were times I had a payment that had to be made but didn't have money in the checking account to cover it," he remembers.
Sometimes it was his rent. Traynor's overdraft line allowed him to pay his landlord on time without incurring a late-payment fee. And while many of his vendors were sympathetic to his cash-flow situation, he had plenty of business-related expenses that needed to be paid upfront--funds he often did not have because of slow-paying customers. Laments Traynor, "Receivables don't always come in quite the way you'd like."
That's where an overdraft line of credit comes in. Set at a predetermined limit, typically in the range of $10,000 to $15,000, this line of credit gives you a flexible way to alleviate temporary cash shortages--you borrow only what you need and pay only for the funds you use. There's so much flexibility in these transactions that the bank may adjust an overdraft-financing limit when a larger funding need arises.
"[If there are] timing gaps in terms of your payables and receipt of receivables, this certainly makes good sense," says Gregory Gault, chief operating officer of Indiana Business Bank in Indianapolis. "If you don't have a working-capital line of credit, then the overdraft line is exactly that."
Unlike some other forms of financing, an overdraft line of credit doesn't generally affect your ability to secure long-term funding because it's considered short-term debt. And as a general rule, the best banks don't even require collateral to set up overdraft financing. "That's why some level of principal reduction is required at the end of the month," Gault says. "If somebody has an overdraft outstanding for more than 30 days, the bank usually sends them an invoice requiring a percentage reduction in [the outstanding balance]. Maybe it's something like 2 percent of the balance or 3 percent of the balance. The payment that the bank will schedule for overdraft protection is going to be calculated more or less the same way credit card payments are calculated. The minimum payment for credit cards is usually a percentage of the outstanding balance."
Convenience, at a Cost
This backup financing arrangement does have some drawbacks. Chief among them is a higher cost of funds. While generally cheaper than a credit card, an overdraft line of credit is more expensive than a commercial loan, with payback rates as high as prime plus 5 percent, according to Gault. "Most small-business owners, if it's a decent business and provides the bank collateral and a guarantee, can get prime plus 1 or maybe prime plus 2," he says.
Additionally, business customers are assessed a fee every time they draw funds against their overdraft line, usually in the neighborhood of $10 per transaction. Even so, that's often significantly less than the "returned item" fee that banks charge for insufficient funds.
As a courtesy, many banks will automatically cover overdrafts without the business customer having a formal overdraft protection plan, as long as the business has a proven track record and is financially stable. "A large amount of it hinges on the customer's relationship with the bank," says Union Bank of California's senior vice president Christy Schmitt. "If you know the client and know that they always cover any overdrafts, [if] you know that they've been around for a long time and aren't going anywhere, and [if] you know that they carry a large average balance-- those all weigh into your decision as to whether or not you're going to honor an overdraft, because it really is an extension of credit."
However, counting on your bank to cover your overdrafts without an overdraft line of credit is a risky strategy: "The more you overdraw, the more it deteriorates the relationship," Schmitt stresses. "It does not set a good precedent on your account." In addition to potentially alienating your banker, you don't have the option of carrying an outstanding balance and paying off the overdrafts over time, as with an overdraft line of credit.
Signs That You've Outgrown It
Both Schmitt and Gault warn that repeated overdrafts can be a sign you're leaning too heavily on payables to make ends meet, and it's time for you to upgrade to a working-capital line of credit. "What it really comes back to is whether something in the range of $10,000 or $15,000 is adequate for your business, or [if you] should be looking at something that's more formalized in the form of a working-capital line of credit," Gault says. "If it seems like your book of receivables is growing to the point where you constantly have $15,000 [to] $20,000 worth of outstanding receivables, at that point, you're starting to grow beyond what an overdraft line of credit can do for you, and you should start thinking about putting something in place that would cover you. When you get above $25,000 [to] $50,000 in receivables, then you probably need to have some form of a working-capital line of credit."
For Traynor, his financing needs changed dramatically when he hired employees. "When I got bigger and started hiring employees, I had to have a credit line," Traynor says. "It's much more important to make sure I have enough money available to meet payroll."
Crystal Detamore-Rodman is a Charlottesville, Virginia, writer who covers the small-business finance market.