Partner Article

Overdrafts - Breaking the Habit

For many SMEs, an overdraft is an essential lifeline. However, research suggests that some companies rely far too heavily on their overdraft facility. Part one of our three-part Vfiles Special Report examines the restrictions and considers the alternatives.

For many small and medium-sized enterprises, life without an overdraft would be inconceivable. However, as banks rebuild their crisis-hit balance sheets and are forced to reassess the creditworthiness of their business clients, SMEs have discovered that the reliability – or even availability – of an overdraft can no longer be taken for granted.

According to research carried out on behalf of ABN AMRO Commercial Finance, SMEs have genuine cause for concern regarding their business finance options. While a significant number of businesses continue to rely on their overdraft facilities, traditional financiers are cutting back on provision, in some cases even denying companies an overdraft altogether.

Research figures

The ubiquity of the overdraft among SMEs is undeniable. Our research suggests that 82% of SMEs surveyed have an overdraft in place to cover unexpected costs, while 67% use their overdraft facility to plug holes in cashflow. On average, businesses reported using their overdraft for 20% of the year. These figures suggest that those SMEs might struggle to remain solvent if funding was not available to cover cash shortfalls; indeed businesses we talked to readily acknowledged this risk, with 89% saying they could not survive for less than three months should their overdraft be withdrawn.

Not only does it remain difficult for SMEs to obtain new finance but also existing overdraft facilities are under threat of either reduction or outright cancellation. A hefty 89% of SMEs taking part in the survey reported changes to their overdraft terms and conditions over the last 12 months. Costs have certainly risen, with 86% of respondents saying fees have gone up. More worryingly, 71% said their overdraft had been reduced in the last 12 months, while 54% had seen their overdrafts withdrawn entirely. New applicants also face challenging circumstances, with 83% saying they had applied for an overdraft in 2012, and 55% saying they had been turned down.

A climate of uncertainty

None of this should come as any great surprise. As advisers to the small business community, you’ll be aware not only of the trends but also the pressure on banks. The high street banks have a duty to both their shareholders and their customers to lend responsibly. They must also comply with the internationally agreed capital requirement regulations set out in the Basel III standard. Approved by industry supervisors, Basel III has a significant impact on lending, ensuring that banks hold more capital and reduce their own borrowing. These tightened restrictions are already leading to reductions or withdrawals of business overdrafts, which in turn contributes to a climate of uncertainty among SMEs.

“Even if a business does have a bank’s full support, an overdraft may not be the ideal solution to a cashflow issue. A high percentage of respondents (92%) admitted breaching their overdraft limit at least twice a year, incurring damaging penalties and possibly even spoiling their relationship with the lender.”
Even if a business does have a bank’s full support, an overdraft may not be the ideal solution to a cashflow issue. A high percentage of respondents (92%) admitted breaching their overdraft limit more than twice a year on average, incurring damaging penalties and possibly even spoiling their relationship with the lender. Other surveys have agreed with this finding. The Business Distress Index, April 2012 – a survey conducted by the Association of Business Recovery Professionals (R3) – found 30% of firms admitting to regularly using their maximum overdraft limit; the highest percentage recorded in the last 12 months. This compares to 17% in the previous quarter.

These, and our own findings, appear to be in tune with the general feeling among the accounting and advisory community. Our survey was discussed in a recent news feature on AccountingWEB, the online community for accounting professionals, where one adviser commented that businesses that started after the financial crisis hit were much less likely to use an overdraft facility. Perhaps we are seeing a new trend emerging, whereby businesses are beginning to explore new and alternative sources of funding.

Reducing dependence

One practical route SMEs can take to reduce their dependence on overdrafts is to improve credit control, especially if dependence on overdraft facilities is a result of late payment by customers or unfavourable agreements that can leave suppliers waiting several months for payment. This issue was recognised by a Government-appointed committee led by former Legal & General chief Tim Breedon, who this year published their report Boosting Finance Options For Business. The report recommends that Whitehall do more to encourage prompt payment. “The priority for Government should be to promote a continuing improvement in payment practices amongst larger companies, entailing both quicker approval of invoices and faster, more certain payment terms,” it says.

But importantly, the Breedon report also highlights the importance of considering alternatives to traditional bank lending. These include the relatively recent emergence of internet-based peer-to-peer funding platforms that put businesses in touch with communities of lenders and equity investors. The report also recommends that the Government make it easier for SMEs to access the bond markets.

Finding the right solution

The key challenge for SMEs is to find finance that is appropriate for their circumstances and, as traditional finance becomes harder to access, advisers will play a crucial role in steering clients to suitable alternatives. The new peer-to-peer networks will certainly play a role, particularly when the requirement is for risk and growth finance, as will the better established sources such as equity investment (from angel and VC through to private equity funds) and mezzanine facilities.

Arguably though, the most pressing requirement for most SMEs is a reliable rolling finance facility, which addresses day-to-day cashflow issues, while also providing headroom for steady growth. As things stand, there are really two options to consider: the overdraft facility, and invoice finance – in the shape of factoring or invoice discounting.

In contrast to the emerging peer-to-peer solutions or aspirations for a SME-friendly bond market, invoice finance is tried, tested and well known both to advisers and their clients. In recent years, increasing numbers have been borrowing against their debtor books. However, even today it’s often seen as a necessary move forced by changes in the lending market, rather than something positive. In fact, for businesses with strong debtor books, invoice finance can offer access to larger sums than may be available through an overdraft.

This Vfiles Special Report will examine the current viability of the overdraft for SMEs, as well as consider the possible alternatives. The financial health of the wider economy will ultimately depend on individual companies considering the pros and cons of the various solutions available.

Read Part 2 here

RUNNING THE INVOICE FINANCE NUMBERS

Find out if your clients could benefit from replacing their overdraft facilities by using our Funding Calculator.

The Calculator offers a quick and simple way to make a realistic comparison between these important funding alternatives on a case-by-case basis. By keying-in some basic information about your client’s business, you will immediately be able to see how the costs and sums available, stack up against each other.

http://www.abnamrocommercialfinance.co.uk/business-overdraft-scrap/index.html

This was posted in Bdaily's Members' News section by Marie Welsh .