Business Finance: Credit, charge, loan, or overdraft?
13 July 2016What is the best way to manage a business’s credit and cash flow needs? Credit cards, charge cards, loans, and overdraft facilities each have pros and cons.
Each business has credit and cash flow needs, and there’s a lot that business owners can do to help their businesses get through busy and quiet seasons.
Source: Google Small Business
But apart from the obvious sales, promotions, and better marketing strategies, business finance can be very helpful for small business and medium enterprises.
We know that the banks are happy to give finance to Australian businesses. As of June 2016, businesses owe $41.5 billion in commercial credit and loans, according to the Australian Bureau of Statistics (ABS, 2016).
Approximately 16% of businesses in Australia applied for some form of credit finance in 2013-14 (ABS, 2015). 93% needed debt finance – either a credit card or another loan that must be repaid – and 84% of businesses who applied were successful in getting it.
In contrast, when small businesses apply for equity finance such as venture capital, they are much less likely to be granted it, with just 40% of applications approved (ABS, 2016). This has been the case for a while, with large businesses more likely to receive venture capital, as we can see from the RBA’s Round Table: Small Business Funding in Australia of 2012.
The number one reason why small businesses (40-45%) reported seeking finance was to maintain short-term cash flow or liquidity.
So it makes sense that the proportion of businesses seeking finance increased with the number of employees the company had to pay: from 15% for firms employing 0–4 people, to 37% of firms employing more than 200 people (Treasury Department, 2012).
Businesses may also be eligible for government funding but this does not typically operate as a day-to-day cash flow solution in the same way that line of credit finance can.
When it comes to accessing credit for the daily operations of a business, there are three broad options that business owners can choose from:
- Business credit cards
- Business charge cards
- Business loans
- Business overdrafts
So which one should business owners use? Well, all three have pros and cons, with different advantages and disadvantages available depending on how you use them. Here’s our CANSTAR guide to understanding business credit cards, corporate charge cards, business overdraft facilities, and business loans.
Business Credit Card
Popularity: 13.8% of SMEs (small businesses and medium enterprises) used a credit card in 2012 (NSW Business Chamber, 2013).
What you need to know: Business credit cards are easy to use, convenient – and some offer rewards. The biggest catch is the interest rate charged, which savvy business owners pay attention to because it can vary significantly between cards and providers.
In terms of interest rate, business credit cards have been edging closer towards personal credit cards as far as interest rates go. The range of 9.99% to 20.24% is now common for standard and low rate business credit cards, while personal credit cards range from 7.99% to 23.50% for purchases.
The major difference between business and personal credit cards lies in their annual fees. All business credit cards charge an annual fee, which ranges from $0 to $1,500, whereas a good handful of personal credit cards do not charge an annual fee at all.
Review the pros and cons when choosing between a business credit card or a personal credit card for your business needs. Some sole traders or small businesses with few credit needs may be able to get away with just using personal credit along with their business transaction account or personal transaction account, while larger businesses may need a dedicated business credit card.
Corporate Charge Card
Popularity: 2.8% of SMEs used “other types” of credit, which may include charge cards, in 2012 (NSW Business Chamber, 2013).
What you need to know: Charge cards are a less well-known option available for businesses. They are a type of card that gets repaid in full every month, usually via direct debit from the business transaction or savings account, so that interest is not charged.
The charge card account usually has no pre-set credit limit, so as long as you repay the balance in full every month, you will not incur penalty fees. This is not an invitation to unlimited spending – purchases are approved based on current spending patterns, repayment history, credit records, and the business’s ability to repay.
Charge cards allow business owners to more easily manage the day to day expenses of the business and its employees. One benefit is that additional cards can be issued on the charge account for employees of the business, each with its own individual credit limit or spending limit per month.
Charge cards also often have flexibility with regards to transacting and repayments, with the ability to choose the billing week and even block purchases at selected merchants. Institutions that offer charge cards understand the importance of the bottom line, and therefore some will offer other features such as shorter processing times, reduced transactions costs, or a rewards program.
The biggest catch when choosing a charge card is that the card must be paid in full at the end of the month. The main cost involved in a charge card is its annual fee. In contrast, a credit card or an overdraft facility are able to carry a balance from one month to the next – but you pay interest on the unpaid balance, and this can make a substantial contribution to the cost of the card.
Business Loan
Popularity: 23.8% of SMEs used a business loan with a loan term of more than 1 year in 2012 (NSW Business Chamber, 2013).
What you need to know: The business loan is one of the main methods of financing longer-term capital and cash flow for many businesses. A loan is issued for a certain amount depending on how much the business can prove they are able to repay. The loan must also be repaid within a set timeframe (the loan term), so it is not an endless line of credit. Business loans can be unsecured or they can be secured by commercial or residential property.
Interest is charged on the balance of the loan, so the faster you repay your business loan, the less you pay in interest over the life of your loan. As for the fees charged on business loans, there’s a big difference between what might be called a “cheap business loan” and a more expensive option. For example, upfront fees in 2016 ranged from $0 to $2,500 for a commercially or residentially secured business loan.
Our Canstar database has revealed what business owners are looking for when it comes to overdrafts and loans for the business:
- Size: 33% expect to need an overdraft or loan for $100,000 – $250,000.
- Security: 74% choose to use commercial property as security for their loan.
- Interest rate: 65% would choose a fixed rate, while 35% prefer a variable rate.
- Provider: 73% select a bank as their lender.
You can compare business loans secured by commercial or residential property on our website.
Business Overdraft
Popularity: 19.6% of SMEs used a line of credit such as an overdraft in 2012 (NSW Business Chamber, 2013).
What you need to know: The good, old-fashioned overdraft is still a significant method of financing short-term cash flow for many businesses. It is a facility attached to a transaction account that creates a line of credit from the lending institution when the business account reaches zero. This means the business can continue to withdraw money or make purchases up to the set credit limit when the account has no funds in it.
Overdrafts can be a form of unsecured credit, or they can be secured against commercial property such as your storefront or office or against residential property such as your home. Typically, unsecured overdrafts have a higher interest rate attached to reflect the higher risk for the lender.
Interest is only charged on the portion of the overdraft that is used. Much like a credit card, the more of the balance you pay, off the less interest you pay. Also similar to a credit card, creating a never-ending debt is not ideal! An overdraft is not a business loan – it’s not a set amount of credit that you need to repay within a certain timeframe – but you still need to pay it off as soon as you can afford to.
When looking in to the pros and cons of an overdraft for your business, look out for extra fees and charges such as an upfront establishment fee and regular account-keeping fees, not just the interest rate. For example, when we rated business overdrafts in May 2016, we found the average ongoing fee on an overdraft with a low balance of $50,000 was a whopping $397/year for secured and $431/year for unsecured, up to a maximum of $850/year. That’s a lot to fork out each year, considering some overdrafts charge no ongoing fee at all.
How does a business overdraft compare with, say, your shortlist of business credit cards? Every business overdraft set-up is different, so only you will know which method of credit will best fit your individual business needs.
As for popularity, our Canstar database in 2016 revealed fascinating stats on the preferences of Australian business owners for overdrafts and loans:
- Size: 33% expect to need an overdraft or loan for $100,000 – $250,000.
- Security: 57% choose to use commercial property as security for their overdraft.
- Provider: 73% select a bank as their lender (rather than a credit union or building society), perhaps due to availability or perhaps due to the interest rates on offer.
Find out how your business could benefit by comparing business overdrafts on our website.
