What is Overtrading?

• It happens when a business expands too quickly without having the resources to support such a quick expansion

Overtrading is most likely to happen when…

• A business makes significant investments in 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 to trade from the expanding capacity

• A long-term contract requires a business to incur substantial costs before customers make payments under the contract

Ratio Warning Signs of Overtrading:

• High revenue growth but low-profit margins

• Persistent use of a bank overdraft

• Significant increases in the payables days and receivables days ratio

• Considerable increase in the current ratio

• Very low inventory turnover ratio

• Low capacity utilisation

What Businesses Can Do to Prevent Overtrading?

• Reduce inventory levels

• Slow the pace of growth until profit margins and cash balances improve

• Lease rather than buy (e.g equipment)

• Obtain longer payment terms from suppliers

• Give customers less time to pay

Drawbacks of Overtrading:

• Cash flow issues:

  • Overtrading can lead to a cash flow imbalance, where a business can't pay its bills or staff. This can happen when a business takes on too much trade without managing it properly. 

• Reduced profitability:

  • A business may cut prices to encourage sales, which can reduce profit margins and make it harder to operate sustainably. 

• Loss of supplier support:

  • Suppliers may be reluctant to continue offering credit if a business starts to fall behind on payments. 

• Excessive borrowing:

  • Borrowing money to pay suppliers and invoices each month is not sustainable. Lenders may ask for a personal guarantee from directors, which can put the business at risk. 

• Poor quality products:

  • Overtrading can lead to a business delivering poor-quality products or services, which can damage its reputation. 

• Legal action:

  • Suppliers or customers may take legal action if a business doesn't pay for supplies or fulfil an order. 

• Insolvency:

  • In extreme cases, overtrading can lead to insolvency and the business being forced to shut down.