Overtrading happens when a business has insufficient financial resources to support the rate of growth in trading. It can be a big problem for companies that expand too quickly.
A business that cannot find appropriate sources of finance to support that growth, can fail – even very profitable businesses can and do fail for this reason.
The underlying causes of overtrading include:
- Rapid growth in sales (especially sales made on credit)
- Unexpected increases in demand for the company’s products
- Securing a large one-off contract
- Major seasonal variations in demand that put pressure on resources
- Problems with getting paid by customers
- Restrictions in credit terms offered by suppliers or lenders
The consequences of overtrading can include:
- Having insufficient cash to meet the company’s commitments to suppliers, lenders, and other creditors
- Being unable to secure credit or borrow on favourable terms (and/or having to put up additional security for debt)
- Pressure to reduce margins in order to generate more sales and more cash – which can compound the problem
There are several steps a company can take to mitigate the risk of overtrading. Forecasting expected cashflows on a regular basis can help management identify potential cash shortfalls and take steps to address any expected shortfall before it actually arises.
Effective working capital management is also an important tool to manage the risk of overtrading; this includes not tying up too much cash in stock; making sure customers pay on time; chasing overdue debts promptly; and taking full advantage of supplier credit terms, where appropriate.
A third step that is crucial to heading off any overtrading problems is to make sure that reliable management accounts are being produced and reviewed regularly. This should help management to identify any early warning signs in connection with overtrading.
If you would like help with any of the issues discussed in this blog, contact us today.