In business, growing revenue and profit is usually seen as something positive.
But there is a downside to growth called overtrading.
This occurs when a business expands quickly and does not have the finance in place to fund growth. The result is a lack of working capital to cover day-to-day expenses while sales are growing.
What is overtrading?
To understand how rapid growth can be a problem in business, we’ll look at a hypothetical example of a company called Growco which produces a product called super-widgets. Due to the popularity of super-widgets, sales are growing at a rapid rate. In the process of making products, more raw materials need to be purchased, factory staff need to be paid and other expenses are incurred.
In addition, many other day-to-day expenses need to be met. After the super-widgets are sold and delivered, customers receive 30-day invoices. Some of which are paid late after 60 or even 90 days.
As Growco’s sales increase, the shortfall in cash to pay for the expenses incurred in producing more super-widgets grows. This is due to the lag time between producing the products and receiving the revenue from sales. When new orders for more super-widgets come in, it’s possible that Growco won’t have the funds to buy the materials or pay staff to produce them and keep the business going.
When business growth exceeds the finance available, overtrading can quickly ruin a business because it does not have the working capital to fulfil expanding orders.
The dangers of growing too quickly
This scenario is typical when a business tries to expand too quickly, or wins a large supply contract and does not have the right finance in place to fund the growth. For example, it might seem like a big victory when a packaged foods producer wins a contract to supply to a major supermarket chain. However, the need for working capital to produce the products will grow suddenly, while the purchaser might take 60 to 90 days to pay the invoices for the goods received. The result is a lack of working capital to continue production.
The same situation can also occur in service businesses that grow rapidly. When this occurs, staff wages and other expenses increase significantly before the income generated from the services is received. While sales are growing, the business might not have the funds to pay the additional expenses needed to take on more work.
In order to overcome the lack of working capital, the company can borrow funds. However, it’s important to choose the right type of finance to avoid a negative cash flow cycle where an increase in interest expenses negatively affects net profit, which results in less working capital. The subsequent decrease in working capital again leads to increased borrowing. This, in turn, leads to more interest expenses, and the cycle continues until the overtraded company eventually runs out of working capital.
Warning signs of overtrading
If a business is growing but is chronically short of cash, most likely it’s suffering from overtrading, which could be loss making. Warning signs of overtrading include:
- Insufficient cash to cover the day-to-day expenses needed to operate the business.
- Low or reducing margins – this is common in competitive markets and has a negative effect on cash flow.
- Difficulty paying key suppliers – if a company gets behind, suppliers might become concerned about the ability to pay for new orders and stop supplying the inputs needed to keep your business running.
Several financial ratios can be used to get a better picture of your cash flow position.
For example, the working capital ratio (current assets ÷ current liabilities) is a measure of a company’s working capital. This ratio can be used to establish whether the business has enough current assets to pay its current debts, with a safety margin for unforeseen losses, such as debts that are hard to collect. The higher the working capital ratio, the better. A ratio of 2, for example, shows that the business has twice as many assets as liabilities, suggesting it’s in good condition. A working capital ratio of less than 1 indicates that the business could be in trouble.
The liquidity (quick assets) ratio ((current assets – inventory) ÷ current liabilities) can also provide a clearer picture of how the business is doing. Generally, companies with a quick ratio greater than 1.0 have enough liquidity to meet their short-term liabilities.
An accountant can analyse the situation and give you a better understanding of these ratios and what they mean for your business.
Steps for preventing overtrading
Fortunately, there are several steps that can be taken to prevent or minimise the effects of overtrading. These include:
- Managing receivables to get paid quicker – staying on top of outstanding debts will bring in cash sooner and prevent overtrading. Other options that can improve cash flow are offering discounts for prompt payments, encouraging automated payments for recurring orders of products or services, or requiring a deposit.
- Negotiating better payment terms with suppliers – for example, getting extended payment terms in exchange for regular or larger orders.
- Reducing or lowering unnecessary costs – this could include not taking money out of the business, delaying salary increases and reducing overheads such as business travel.
- Monitoring and forecasting cash flow – paying attention to the cash coming into and flowing out of the business will help to plan for potential shortfalls in working capital. Having a cash flow statement that is updated regularly as conditions change makes it possible to monitor the business and adjust when necessary.
- Using unsecured short-term finance when you have a cash flow shortage. Our friendly Brokers can assist you here, enquire now!
In general, businesses need to plan for growth and have strategies in place to grow within their means. They should also consider the options available such as unsecured business loans. More businesses are now choosing unsecured loans because they are a quick and simple solution that can help overcome short-term cash flow challenges.
Business publications and websites regularly publish stories about growing businesses that failed when everything seemed to be going right. In many cases, overtrading was the cause. Knowing where a business stands and taking the right steps can prevent or minimise the effects of overtrading.