A Reference Guide to Trade Finance TechniquesOverdrafts
Overdrafts can be an effective way to finance
working capital. Where offered, they are
usually relatively flexible, although this will
depend on any terms and conditions applied
by the bank offering the facility.
How it works
An overdraft facility allows a company to
run its current or checking account with a
debit balance. Overdraft facilities should be
pre-arranged and are sometimes offered by
banks without the need for formal security.
Where available, overdrafts are usually
renewable on an annual basis, although
in certain jurisdictions a bank may require
funds to be repaid before a facility is
renewed. In some locations it is common
practice to turn an informal overdraft into
a committed facility after a period, often a
month (see next section).
Advantages
Overdrafts are easy to operate. Because
they are often unsecured, overdraft
facilities can be set up fairly quickly
without the need for complex legal
documentation.
They provide an additional comfort barrier
for companies operating internationally
that face a degree of uncertainty in the
timing of the receipt of payments from
their counterparties. However efficient a
company’s collection process, there is
always the risk that a payment due will be
received later than expected. An overdraft
facility means payments can still be
disbursed on the strength of an anticipated
collection, without the risk of dishonour by
the bank.
They often do not require formal security.
This means assets can be used as
security for other financing opportunities.
However, the overdraft provider may
restrict the company’s ability to assign its
more liquid assets to other lenders.
Overdrafts can be arranged by companies
of all sizes.
Disadvantages
Overdrafts are not available everywhere,
through either market practice or regulation.
Some countries prohibit companies from
arranging any unsecured overdrafts. In
Venezuela, for example, account holders
are prohibited from writing cheques with
insufficient funds to support them.
Their availability may be restricted to
short periods. Some banks may only offer
unsecured overdrafts for periods up to
about a month; for longer periods, they
may insist on converting the arrangement
to secured borrowing. In some countries,
such as Poland, banks require companies
to clear their overdraft facilities once a year.
Banks can withdraw overdraft facilities on
demand. A bank is most likely to withdraw
such facilities from a company which relies
on them, simply because such companies
represent the greatest counterparty risk
to the bank. In 2009 a number of UK
companies reported that their banks had
withdrawn part of their overdraft facilities
when the UK government arranged a
moratorium on the payment of VAT.
However it occurs, any withdrawal of
overdraft facilities from a company which
relies on them (whether as a permanent
source of funds or as the funding of last
resort) will put significant pressure on that
company’s cash flow. This is particularly
the case when the bank gives very short
notice of the withdrawal of facilities, as the
company has little time or opportunity to
arrange alternative funding.
Because they are unsecured, overdrafts
are often a relatively expensive method of
arranging finance. For example, overdrafts
in Mexico are usually charged at more than
double the prevailing rate on treasury bills.
The regulatory treatment of overdrafts is
less favourable than other techniques,
such as invoice discounting. To cover
the capital costs associated with such a
facility, banks are more likely to impose a
facility fee and a non-utilisation fee.
They can indicate a degree of
inefficiency within the company’s
treasury department. The existence of
overdraft facilities can weaken pressure
on treasurers to manage cash tightly,