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Study Notes

Overtrading

Level:
AS, A-Level
Board:
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)

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