- AS, A-Level
- AQA, Edexcel, OCR, IB, Eduqas, WJEC
Last updated 22 Mar 2021
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 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 occur if:
- 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 a bank overdraft facility
- Significant increases in the 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. For example:
- 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 (e.g. through prompt-payment discounts)