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
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
Reducing inventory levels
Scaling back the pace of revenue growth until profit margins and cash reserves have improved
Leasing rather than buying capital equipment
Obtaining better payment terms from suppliers
Enforcing better payment terms with customers (eg, through prompt-payment discounts)