What are the dangers of overtrading?

Overtrading is a serious threat to growing businesses, and can quickly cause once profitable companies to become insolvent if this increase in trade is not sufficiently managed. The situation typically occurs when businesses grow at a rapid rate – at a rate that’s too rapid given the additional resources they suddenly require, before any payments have been received from the new customer.

Securing a large new contract would normally be seen as a cause for celebration and the key to securing a business’ long-term future, but unfortunately this isn’t always the case. There may be a shortage of resources such as machinery, equipment or staff, and crucially, the cash flow with which to pay for them.

What else can cause overtrading?

Other causes of overtrading include seasonal business trends which consume a company’s resources at certain times of the year, or a sudden increase in demand which may have to be dealt with unexpectedly.

But there’s another factor that plays a negative role in this overall scenario, and that’s the late payment of invoices by the company’s debtors. When the money owed to a company isn’t collected quickly or efficiently enough, the company’s ability to meet its obligations is compromised.

Even a delay of just a few days can significantly reduce the availability of working capital at a vital time. So given this unstable background to some business operations, what are the specific hazards of overtrading?

Dangers of overtrading

Lack of cash

Without a healthy cash flow, it’s always going to be difficult to balance all the needs of the business. One planned outcome has to make way for another, and the company’s entire strategy can be compromised.

Excessive borrowing

Borrowing money simply to pay the bills each month is a desperate situation for any business, and one that isn’t sustainable. Banks may begin to ask for a personal guarantee from one of the directors to mitigate their risk if you ask for further borrowing.                  

Reduced profit margins

The company may decide to cut prices, and consequently profit margins, to encourage sales and improve turnover. This makes it ever more difficult to operate a sustainable business, particularly if the market is very competitive. 

Loss of supplier support

Suppliers may be happy to provide the extra resources needed by the business, but will be reticent to offer credit for increasing levels of supplies if they start to fall behind with payments. It’s likely the supplier will restrict orders until their debt has been paid, further complicating the company’s position if there are no viable alternative suppliers. Effectively, the company is now unable to fulfil the contract for two reasons – little working capital and lack of supplies.

How to avoid overtrading

• Being aware of the possibility and significance of overtrading is the first step in avoiding it. Insolvency occurs when there is insufficient cash with which to pay the bills as they fall due, or if the company’s liabilities are greater than the total of its assets. Keeping an eye on cash flow, therefore, is a major factor in running a sustainable business.
• Preparing regular cash flow forecasts helps to highlight when a cash shortfall is likely, and allows directors the opportunity to secure finance if necessary, or at least ensure that debts are collected efficiently.
• Making sure that working capital isn’t needlessly tied up in stock can also provide the cash needed to run a business smoothly. Ordering inventory just before it’s needed, rather than too far in advance, helps to even out the peaks and troughs experienced by most businesses.
• Effective credit control supports healthy cash flow, and provides the working capital needed on a day-to-day basis. From offering realistic credit limits to new and existing customers, to rigorously chasing payments using an effective system, good credit control is key to avoiding overtrading.

What if overtrading is already a problem?

A number of solutions can correct the problem of overtrading – for example:

• Rather than purchasing machinery or equipment on credit terms, leasing it can sometimes be cheaper.
• Being aware of alternative methods of finance, such as factoring and invoice discounting, can help to secure vital funding quickly. Invoice finance provides regular cash injections throughout each month, and is based on the value of a company’s sales ledger.
• Keeping reliable management accounting information enables accurate forecasting of a company’s cash needs, and the likely incoming payments.
• Seeking professional help will ensure all the options are considered.

Begbies Traynor specialises in business rescue and recovery, and can provide the professional guidance you need if you’re at risk of overtrading. With more than 70 offices nationwide, we offer a same-day consultation free-of-charge.