Overtrading happens when a business expands too quickly without having the financial resources to support such a quick expansion.
- If suitable sources of finance are not obtained, overtrading can lead to business failure.
- Importantly, overtrading can occur even when a business is profitable. It is an issue of working capital and cash flow.
- Overtrading is, therefore, essentially a problem of growth.
- It is particularly associated with retail businesses who attempt to grow too fast.
Overtrading is most likely to happen when
- Growth is achieved by making significant capital investment in production or operations capacity before revenues are generated
- Sales are made on credit and customers take too long to settle amounts owed
- Significant growth in inventories is required in order to trade from the expanding capacity
- A long-term contract requires a business to incur substantial costs before payments are made by customers under the contract
Classic symptoms of overtrading
- High revenue growth but low gross and operating profit margins
- Persistent use of bank overdraft facilities
- Significant increases in payables days and receivables days ratios
- Significant increase in the current ratio
- Very low inventory turnover ratio
- Low levels of capacity utilisation
Managing the risk of overtrading
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The most effective steps to avoid overtrading are essentially those that would be taken as part of a sensible cash flow and working capital management
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Reducing inventory levels
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Scaling back the pace of revenue growth until profit margins and cash reserves have improved
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Leasing rather than buying capital equipment
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Obtaining better payment terms from suppliers
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Enforcing better payment terms with customers (eg, through prompt-payment discounts)