What is Overtrading and how to prevent it
Overtrading means s situation of operating a business entity with insufficient long term capital to support the current volume of business. Overtrading can arise even if the organization is trading profitably. Over-expansion of business is one of the main reasons for overtrading and therefore overtrading is also called under-capitalization.
- Why should Working Capital be managed efficiently
It is very important to manage working capital efficiently. This is important from the point of view of both liquidity and profitability. Even the most profitable business can quickly go under if it does not have sufficient liquid resources. But ....
A swiftly growing business requires additional levels of inventory and receivables to support the growth. This means the working capital requirement increases. When this increase becomes permanent, it should be financed with additional long term capital. When it is financed from a bank overdraft and a shorter operating cycle, the business entity could easily run into severe liquidity problems.
The commonly seen symptoms of overtrading :
- Rapid increase in revenue
- Decrease in liquidity ratios
- Piercing increase in sales to non-current assets ratio
- Rise in inventory in relation to revenue
- Increase in receivables
- Rise in the accounts payable period
- Increase in short term borrowing
- Decline in cash balance
- Increase in gearing level
- Decrease in profit margin
When a business organization fails through liquidity problems, overtrading can be the result. One possible solution to the problem of overtrading is to reduce the level of revenue. The business can increase selling prices thus increasing the profit which may reduce the demand.
Managing debts effectively and proper credit control will help to prevent overtrading. It will ensure that the company is paid more efficiently and has cash to pay suppliers and salaries to staff.
Possible approaches to effective debt management are given below.
- Setting new payment terms
Re-negotiate payment terms or introduce new terms for future orders. Here success will depend on the strength or weakness of the company in the industry or its competitive position in the market. If the new terms are not attractive to customers the company may lose business.
- Offering discounts for prompt payments
This will accelerate payments, boost cash flow and reduce bad debts. It can be expensive to the company and customers may not take the offer if not attractive.
- Automated payments
This will prevent the risk of bounced or lost cheques.
- Invoice discounting or factoring
Factoring means selling invoices to an expert finance company who take over the administration and the cost of recovering the payments.
- Negotiating terms with suppliers
Suppliers can be asked to grant longer payment terms but here some suppliers may refuse to continue to trade with the company on credit terms.
- Improve inventory control
Quicker inventory turnover will cut the time between paying some suppliers for goods and customers payments
Lease/Hire purchase assets
This will help smooth cash flows to acquire non current assets.
- Introduction of new capital
The company can issue new share capital or obtain long term loans.
- Reduce distribution of profit
Avoiding payment of dividends will improve cash flow but this may not be a welcome suggestion.
- Cost cutting
Cost reduction improving efficiency should increase cash flow and reduce risk of over trading.