Overtrading: Definition, Causes, Consequences and Remedy
We have heard the word “Overtrading” used by bankers, credit rating organization and analysts. It’s therefore important to understand what is Overtrading, how it is cause and what serious repercussions will happen and as financial executive what we can do.
So what is Overtrading?
In simple word, it denotes a condition in which the resources in particular the liquid resources of a business are insufficient to maintain the existing level of trading. This particularly happens during the booms when companies increase revenue without considering it means to finance the increase turnover.
In colloquial terms, we can also say that the management has failed to cut their coat according to their cloth.
The Causes of Overtrading are as follows:
Internal Factors:
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By expanding turnover without the correspondingly increase in working capital. For example, assuming the present turnover is $12 million and average debtors of $250,000. If turnover increase by 30% and assuming the same credit terms on the new turnover, its debtors are likely to rise by 30% i.e. $750,000. So this $750,000 needs to be obtain from existing working capital resources or injection of share capital. If management ignores this point by “overstretching”, it will face the “Overtrading situation”,
- By increased investment in fixed assets like land and building, machinery, etc and acquiring investments in a subsidiary or associated companies without a corresponding increase in equity or borrowings. Any increase in the above-mentioned capital expenditure will then deplete the net current assets,
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By allowing a longer than usual cash conversion cycle namely by the increase in stock levels and extending exceptionally long credit,
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Through trading losses which will reduce the net current assets. This also happened in cases of abnormal losses like redundancy payments, additional contribution to pension funds, payments of damages and others.
External Factors:-
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Changes in taxation rates or system. Higher amount of tax payable will deplete the net current assets,
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Changes in the date of payment of taxes.If the date of payment is brought forward, working capital will fall which causes financial strain during the period,
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Cutbacks in bank lending. In the event there is cutback where the company cannot find the funds to meet its debt, an Overtrading situation can occur,
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Inflation and Price Control. Inflation will basically mean the need to have increased investment to maintain the existing physical monetary inventories like raw materials, work in progress and finished goods whilst price control will erode margins hence reducing net cash flow.
After understanding what is Overtrading and the causes, next we should need to know what serious repercussions will happen to the company if this overtrading trend is still not curbed:
- Inability to pay creditors on time, hence the reputation will be at stake,
- Increased purchase cost due to inability to benefit from cash discounts from the suppliers, unable to buy in bulk hence losing quantity discount and choosing suppliers who are willing to extend credit terms but with higher prices and or lower quality,
- Due to the need for cash to pay creditors and others, we might pressurize the debtors to pay early,
- Reduce stocks level unnecessarily which affects the business operation,
- By offering too liberal discounts to encourage prompt payment from debtors hence affecting the bottom-line results,
- Deferring the crucial investment in capital expenditures or delaying the maintainance of important facilities infrastructure which are crucial to generate incomes from these fixed assets,
- Inability to pay the salaries of the employees hence delaying the time of payment until money is received from the debtors. This will cause very low morale to the employee which will affects productivity and others,
- Inability to pay taxes which will put the company in bad book of the authority,
As financial executive, it is crucial that we are able to spot or detect the following danger signs/warnings of Overtrading. Append below are at least some of the danger signs/warnings which we must take note:-
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Pressure on existing cash
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Exceptional cash generating activities like offering very high discounts for early cash payment or selling off of company assets which are not idling
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Bank overdraft exceeds authorized limit
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Seeking greater overdrafts or lines of credit
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Part-paying suppliers or other creditors
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Paying bills in cash to secure additional supplies
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Management pre-occupation with surviving rather than managing
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Frequent short-term emergency requests to the bank to help pay wages, pending receipt of a cheque
- The liquidity ratio namely the quick assets and current assets ratio are deteriorating quite badly,
- Turnover/equity shareholders funds rises excessively,
- Trade creditors increasing faster than turnover. Also, we can see that the ratio for average credit days from creditor trend is increasing dramatically,
- Progressive reduction in liquid resources. Positive cash balances turning into negative bank overdrafts facilities or trade facilities like bill payables and others,
- Borrowings increases without corresponding increase or injection of share capital. If the gearing ratio rises excessively we needs to analyze the reasons or cause,
- The charging of more and more assets to secure loans as more and more is borrowed,
What then are the remedies for Overtrading?
Well the answers are obvious:-
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Cut the coat smaller or
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Obtain some more cloth
- Is Your Company A Going Concern Outfit?
- Ratio Analysis: Which Ratios Have the Most Value?
- Cash Conversion Cycle Definition And Overview
- Order-To-Cash Cycle: Definition,An Overview, Benefits, KPA and KPI
- A Simple Credit Vetting Or Evaluation Checklist
April 16, 2006
Tags: Overtrading
Posted in: Ratio Analysis
6 Responses
the site is good and is quite informative
i think there is a mistake in the first internal factor causing overtrading. if my calcultions are correct an increase by 30% in debtors amounts to $75,000 and not $750,000. this must be a type error
What is the symptoms for overtrading?
very helpful indeed..
What Are The Reasons For The Decrease or Depletion Of Working Capital? | Basic College Accounting.com - May 8, 2009
[...] The company has expanded too fast. By expanding too fast without increasing its working capital, this will further deplete the working capital of the company. This situation is also called “OVERTRADING” Click here To understand more about OVERTRADING [...]
The article was very helpful in my studies of BBA
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