An overdraft is a flexible borrowing facility attached to your business bank account that lets you spend more than your current balance, up to a pre-agreed limit. Unlike a business loan, you only borrow what you need and only pay interest on the amount you actually use.
Overdrafts are a form of short-term debt financing designed to help businesses manage cash flow gaps rather than fund long-term investments.
How a Business Overdraft Works
When your bank grants an overdraft facility, it sets a maximum limit you can go overdrawn. If your account balance is £5,000 and your overdraft limit is £10,000, you can spend up to £15,000 in total before being blocked.
Key features include:
- Revolving credit — As you repay, the facility becomes available again
- Interest on usage — You only pay interest on the overdrawn amount, not the full limit
- On-demand repayment — The bank can technically recall the facility at any time, though in practice they usually give notice
- Annual review — Most business overdrafts are reviewed and renewed yearly
Arranged vs Unarranged Overdrafts
Arranged Overdraft
An arranged overdraft (also called an authorised overdraft) is formally agreed with your bank. You apply for a specific limit, the bank assesses your business, and if approved, you have a set borrowing facility.
Unarranged Overdraft
An unarranged overdraft occurs when you go overdrawn without prior agreement, or exceed your arranged limit. This is significantly more expensive and can result in:
- Higher interest rates (often 3 to 4 times the arranged rate)
- Daily or monthly fees
- Declined payments and returned direct debits
- Damage to your business credit score
Since FCA regulations tightened in 2020, personal overdraft pricing has simplified, but business overdraft charges still vary widely between providers.
Costs and Fees
Business overdraft costs typically include several elements:
| Cost Element | Typical Range |
|---|---|
| Interest rate (EAR) | 5% to 15% on arranged overdrafts |
| Arrangement fee | 1% to 2% of the facility limit |
| Annual renewal fee | £50 to £500+ depending on the limit |
| Unarranged usage fee | Up to 30%+ EAR, plus daily fees |
| Non-usage fee | Some banks charge for having the facility available even if unused |
Because interest is charged daily on the overdrawn balance, the actual cost depends entirely on how much you use and for how long. An overdraft that is cleared regularly is far cheaper than one that remains at its limit for months.
When to Use a Business Overdraft
Overdrafts are best suited for:
- Seasonal fluctuations — Businesses with predictable busy and quiet periods, such as retail or tourism
- Invoice timing gaps — When you have paid suppliers but are waiting for customers to pay you
- Unexpected short-term costs — Emergency repairs, urgent stock purchases, or payroll timing issues
- Day-to-day cash flow management — Smoothing out the peaks and troughs of normal trading
They are not well suited for:
- Purchasing large assets (consider asset finance instead)
- Funding long-term growth (a business loan or equity financing is more appropriate)
- Covering persistent losses (this signals a deeper problem that borrowing will not solve)
Overdraft vs Business Loan
| Feature | Overdraft | Business Loan |
|---|---|---|
| Structure | Revolving credit line | Lump sum with fixed repayments |
| Interest | Only on amount used | On the full loan amount |
| Repayment | Flexible, no fixed schedule | Fixed monthly instalments |
| Term | Ongoing (annual review) | Set term (1 to 25 years) |
| Best for | Short-term cash flow | Planned investments and purchases |
| Cost | Can be expensive if used long-term | Usually lower interest rate for the same risk |
If you find your overdraft is permanently utilised, it may be more cost-effective to convert that borrowing into a fixed-term loan with lower interest.
How to Apply for a Business Overdraft
- Review your cash flow — Understand your typical peaks and troughs to determine the right limit
- Approach your bank — Your existing business bank is usually the best starting point
- Provide financials — The bank will want to see recent management accounts, bank statements, and cash flow forecasts
- Agree terms — Negotiate the limit, interest rate, and any fees
- Annual review — Be prepared to provide updated financials each year for renewal
Maintaining clean accounting records makes the application and renewal process considerably smoother.
Overdraft on the Balance Sheet
An overdraft appears as a current liability on your balance sheet because it is repayable on demand. In cash flow statements, overdrafts are sometimes treated as a component of cash and cash equivalents if they form an integral part of the company’s cash management.
Interest paid on a business overdraft is an allowable expense for Corporation Tax purposes, reducing your taxable profit.
Managing Your Overdraft Effectively
- Monitor daily — Keep a close eye on your bank balance and overdraft usage
- Set internal limits — Do not use the full facility as a matter of course; keep a buffer
- Chase invoices promptly — The faster customers pay, the less you rely on the overdraft. Consider invoice factoring if late payment is a persistent issue
- Forecast cash flow — Anticipate when you will need the facility and plan accordingly
- Review annually — Reassess whether the limit is still appropriate and whether a different product would be cheaper
Alternatives to an Overdraft
If an overdraft is not the best fit for your situation, other options include:
- Invoice factoring — Unlock cash from unpaid invoices immediately
- Business loan — Fixed-term borrowing for planned expenditure
- Business grants — Non-repayable funding if you qualify
- Credit cards — For smaller, short-term purchases (though interest rates can be high)