What is Overtrading - Adam Wong

Overtrading is attempting to sustain a level of activity (production and sales) which is too high for the
financial resources of the business. Bankers often refer to a company which is overtrading as being under
capitalised. The phenomenon occurs mainly in smaller companies which are growing too fast and the
working capital requirement is growing faster than the profit/cash flow being generated. Overtrading may
occur in very profitable companies if the dividend policy is unduly generous and if too much of the business
resources are directed to fixed asset expansion.

Identification
The primary indicator of possible overtrading is a rapid increase in the sales to working capital ratio.
If the movement in the relationship between sales and working capital suggests that the business might be
overtrading there are various other signs which are likely to occur if overtrading actually exists. They are
as follows :-

Overdraft facilities are likely to be consistently fully utilised with a rapid development of significant levels of
hard core borrowings and frequent use of excesses together with regular requests for increase in facility.

The current ratio decreases reflecting increased dependence on short-term borrowing.

The acid test ratio also decreases for the same reason.

Gearing increases, with overtrading the dependence on borrowed funds increases and more particularly,
the dependence on short-term borrowings increases rapidly.

Credit taken from suppliers tends to increase.

Credit given to customers may decrease because of the continuing need for cash; companies which are
overtrading tend to pressurise customers for fast payment and regularly offer discounts for prompt
payment or cut prices for sizeable orders when cash can be assured. Such companies may also factor their
receivables.

Replacement of fixed assets is deferred or, where assets are replaced, leasing or hire purchase may be
used.

Stock-outs may occur in either the raw materials area (thereby producing production scheduling problems)
or in the finished goods area (thereby creating problems with customers).

Profit margins may deteriorate, a number of factors combine to produce this result.
- Interest increases as a result of the increased borrowing;
- Discounts given to customers may increase;
- Discounts received from suppliers may be lost, thereby increasing the cost of materials;
- Due to increased repairs and maintenance costs resulting from deferral of fixed asset renewal;
- Production scheduling problems resulting from either plant breakdowns or stock shortages.

Sales to capital employed ratio increases. From the point of view of productive use of resources, this is
not an undesirable development but it can result from inadequate working capital which is not desirable.

The lender monitoring the account may notice :
- The continuous use of the full amount of the overdraft facility probably with regular excesses;
- A hard core on the account;
- A similar increase in the incidence of post-dated cheques;
- An increase in the number of marked cheques;
- An increase in the number of credit enquiries from other banks;


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