How large an overdraft do you need?
While there is much to be said for the old adage ‘bigger is better’, a question we often field from the banks of our clients is ‘how large an overdraft do you require?’
It turns out you can inform this once you understand how cash flows in & out of your business, & what purpose an overdraft serves.
Let’s address the latter point first. An overdraft is a fixed credit limit typically linked to the main trading account for a business. It allows a business to dip into a negative bank balance without incurring fees (though you will pay interest) & nasty calls/letters from your banker. It is the bank's permission to overdraw your account. If you’ll allow me to nerd out for a moment – remember that ‘draft’ once was common for measuring depth in old sailing vessels. Hence OVER-DRAFT…
Point is, an overdraft is there to cover what a bank would call your Working Capital requirements. That being, the cash used up in order to obtain your primary income. Think about how on a job you’ll often have to pay for materials prior to receiving payment from the customer. At different points your working capital need can be positive or negative. An overdraft allows for this to be flexible & for you to invest your cash elsewhere in the business (i.e. to purchase a new machine or factory) & obtain a rate of return surpassing the interest paid on the overdraft itself.
This begs the question – how do you understand your working capital requirements?
Well, it turns out there is a ratio for just this. You can calculate a Working Capital Absorption Rate (WCAR). Expressed as a percentage this rate implies that for every dollar of revenue a percentage of that dollar will be ‘absorbed.’
For instance, say your WCAR has been 10% for the past couple of years, & you expect $1M over the coming 3 months. Then your overdraft limit should be $1M * 10% = $100K – assuming you have $0 in the bank to begin with. If you have say $300K surplus in the bank, then chances are you should not need your overdraft.
Below is a snapshot from Fathom explaining WCAR & it’s calculation.
Where it gets really interesting…
Is it possible for a business to have rising sales, be profitable, but still collapse into insolvency? You bet!
...If the WCAR is higher than the Gross Profit Margin %.
To explain, lets say your Gross Profit Margin is 20%, but your WCAR is 30%. That means the profit you receive from your work will not fulfill your working capital requirements. On average you will be short 10 cents in every $ of revenue.
What does that mean?
Well if you do not do anything about it, it means for every additional dollar of revenue created you are going to have to source 10c in NEW DEBT just to make sure your bank balance does not go down.
Remembering debt has a limit & it has to be paid… See the issue.
Fortunately there are several drivers of the Gross Profit Margin & WCAR so if the issue can be spotted early enough serious trouble can usually be avoided.
Want to better understand your profit & cash flow drivers? Use the promo code ‘Insights’ for an extended 60-day trial of Fathom, or email David Maher, RBI’s Director at email@example.com & he will gladly talk you through your numbers over a coffee.