Avoid the problems of overtrading

Overtrading is an imbalance between the work that a business takes on and its capacity to do the work.

It happens when a business takes on work, but does not have enough current assets, or working capital, to meet the resulting demands.

This is particularly common in young, rapidly expanding businesses. It can be extremely serious, even fatal to an organisation, so it’s worth taking time to understand how to prevent it happening to your business.

This guide explains what overtrading is, how it can occur and how to avoid it.

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What is overtrading?

Overtrading takes place when a business accepts work and tries to complete it, but finds that fulfilment requires greater resources – ie more people, working capital or net assets – than are available. This is often caused by unforeseen events such as when manufacture or delivery take longer than anticipated, resulting in cashflow being impaired.

Working capital is the difference between current assets and current liabilities. In the following example, working capital, or net current assets, amounts to £3,000.

Working capital

	£
Current assets
Stock	66,000
Debtors (owing by customers)	37,000
TOTAL ASSETS	103,000
Current liabilities
Creditors (owing to suppliers)	71,000
Bank overdraft	29,000
TOTAL LIABILITIES	100,000
Net current assets	3,000

Whether or not £3,000 is sufficient working capital depends on the circumstances of the business.

Overtrading is a common problem, and it often happens to recent start-ups and rapidly expanding businesses. Cash often has to leave the business before more cash comes into it. For example, wages and salaries are usually payable weekly or monthly, and there may be other expenses that need to be met promptly, such as telephone bills and rent.

Although you may pay suppliers on credit, your customers may also pay you on credit. It doesn’t take much to upset the balance.

It is also possible to run out of cash, even if your customers pay cash and do not have credit accounts. For example, you may have to pay suppliers quickly, perhaps even in advance, or you may have to hold stock for a long time. What matters is the amount of working capital and the timing of cash coming in and going out.

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Matching sales and production cycles

There can be many causes and contributory factors, but for manufacturing businesses a mismatch between sales and production cycles is often at the heart of an overtrading problem.

It follows that the problems can be at least reduced, maybe even eliminated, if the sales and production cycles can be matched.

If you are a trader, you may be able to hold stocks for a shorter period. If you are a manufacturer, you may be able to hold fewer components for a shorter period and speed up the manufacturing process.

Just-in-time

It may be helpful to employ just-in-time (JIT) techniques. As the name suggests, this is where goods and materials are delivered just in time for you to use them. JIT systems can help you with:

• shortening the manufacturing cycle
• reducing the period that you hold stock
• reducing the need for working capital

However, JIT systems may not be easy to establish. One problem is that there are no obvious benefits for your suppliers. Indeed it could be a disadvantage for them, because they will probably have to invest in new systems, hold stocks themselves and make frequent small deliveries.

For this reason, JIT often works best when you are able to work as a team with your suppliers. To achieve this you may need to give them something in return, such as guaranteed regular orders or even on-delivery payment.

A potential disadvantage of JIT is that you are cutting down your margin of safety. You will need to ensure you have good systems, good planning and reliable suppliers if it is to work.

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Assessing your cash needs: assets and liabilities

It is often helpful to compare the assets and liabilities of your business, as it can be useful for forecasting what your assets and liabilities will be in the future. You can do this by using cashflow forecasting and ratio analysis. However, for either to be effective, you need up-to-date and reliable financial records.

Cashflow forecasting

Since cash is essential to a business, a cashflow forecast is one of the most important management tools you can use. If you are expecting a rapid increase in business, an accurate cashflow forecast is vital. This predicts the money coming into and going out of the business and, to be effective, it needs to be broken down into relevant periods – monthly, weekly, or even daily.

This will tell you whether the extra demand can be effectively financed, whether you need extra short-term financial support, or whether there is a risk of overtrading. See our guide on cashflow management: the basics.

Ratio analysis

There are various ratios that need to be monitored in order to avoid overtrading. Along with cashflow forecasting, these ratios will help you understand your own business’ cash needs. Forecasting future ratios is an invaluable way of predicting the effect of a rapid increase in workflow.

Read explanations and examples of different types of efficiency ratio on the Business Owner’s Toolkit website- Opens in a new window.

Working capital and quick ratio

Working capital is the difference between current assets and current liabilities. Clearly, the safest position to be in is to have more assets than liabilities, and the bigger the difference the better.

Quick ratio is a similar but more demanding way of measuring cash needs. Stock is completely left out of the current assets total because it might take some time to turn into cash. Only investments, money in the bank, cash and money owed by customers are counted.

A good score in the quick ratio test is usually an indication of a healthy business.

Read explanations and examples of working capital and quick ratios on the Business Owner’s Toolkit website- Opens in a new window.

Gearing

This is the percentage of money borrowed from the bank compared with money provided by the owners and other investors. For example, suppose that the bank lends the business £40,000 and the shareholders provide £60,000. The gearing would be 40 per cent, because the bank provided 40 per cent of the total.

Gearing can help a business by boosting cash, but it does involve borrowing potentially large sums of money. There is no set safe figure for gearing, because businesses differ so much. Essentially though, the higher the gearing, the higher the risk.

Because of those risks, banks are often wary of lending too much and might refuse to accept gearing of more than, say, 50 per cent.

Read information on financial ratio analysis and gearing on the Biz/ed website.

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Assessing your cash needs: creditors and debtors

In order to assess your cash needs accurately you need to use accurate, up-to-date figures or, when these are not available, use forecast figures.

You can avoid overtrading by checking your cash needs using financial tests such as gearing, working capital or the quick ratio tests. See the page in this guide on assessing your cash needs: assets and liabilities.

Two other useful comparisons are debtor days ratio and creditor days ratio.

Debtor days ratio

This shows how long, on average, your customers take to pay you. For example, your customers owe you £14,000 on a given date. Your annual turnover is £100,000. Multiply the amount owed by the days in the year, 365, and divide the result by the annual turnover, £100,000:

(£14,000 x 365)/£100,000 = 51 days

So each customer is taking 51 days, on average, to pay. Remember this calculation can be distorted if your business is very seasonal, so it works best if your invoices are spread evenly throughout the year.

Creditor days ratio

This shows how long, on average, you are taking to pay your suppliers. For example, you owe your suppliers £9,000 on a given date and across the year you pay out £150,000. Multiply £9,000 by the days in the year, 365, and divide the result by the total amount you pay:

(£9,000 x 365)/£150,000 = 22 days

Suppliers are, on average, being paid in 22 days. Again, seasonal differences can influence the results so this calculation works best when your purchases are made evenly during the year.

If you pay your creditors more rapidly than you are paid by your customers, you will need a high level of working capital.

Read information on financial ratio analysis on the Biz/ed website – Opens in a new window.

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Avoid the problems of overtrading: debts

Effective debt management and credit control can help you avoid overtrading, by ensuring that you get paid more efficiently and have the cash to pay suppliers and staff.

In addition to managing debt more effectively and improving credit control, you should also think about changing some or all of your business practices.

Set new payment terms

You could renegotiate payment terms, or tell customers that new terms will apply for future orders, but you should be aware that customers may object. Much will depend on the strength or weakness of your competitive position. You may lose business if your new terms are unattractive to your customers, or if you are aggressive in imposing them.

Offer discounts for prompt payment

This can be effective in accelerating payment, boosting cashflow and reducing bad debts. However, there are disadvantages – it can be expensive and must be policed to ensure that customers only take discounts when they pay promptly. See our guide on invoicing and payment terms.

Encourage automated payments

Automated systems of payment should be encouraged over more traditional methods such as sending cheques by post. Using systems such as BACS or CHAPS will prevent the risk of bounced, missing or lost cheques and have the advantage of providing payment certainty. Read about BACS payments on the BACS website- Opens in a new window. You can also read about CHAPS payment on the UK Payments Administration website- Opens in a new window.

Use factoring or invoice discounting

Factoring involves selling your invoices to a specialist finance company which takes on the administration and cost of recovering the invoice payments. With invoice discounting, you raise a loan from a finance company against the value of your invoices, but you keep the responsibility and cost of recovering invoice payments. See our guide on factoring and invoice discounting: the basics.

Negotiate payment terms with your suppliers

You could try to negotiate different payment terms with your suppliers. Simply taking longer to pay may be considered unethical, and you may find that some suppliers refuse to supply you if you habitually take too long to pay. Businesses are also entitled to charge interest on late payments.

You may therefore want to consider giving something in return for extended payment terms, such as a promise of regular orders.

For more information on how to ensure that customers pay their bills on time and why you should pay your suppliers on time, see our guide on getting paid on time.

Improve your stock control

It costs money to hold stock and raw materials, so turning them over more quickly will cut costs.

Faster stock turnover means that there will be a shorter interval between the time that you have to pay your suppliers and the time that your customers pay you for the same goods.

There are many other solutions. See the page in this guide on how to avoid the problems of overtrading: assets.

You can also see our guide on managing late payment.

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Avoid the problems of overtrading: assets

One way you can help prevent overtrading is by keeping a tight control of the money you have going out of your business to pay for assets.

Lease your assets or buy them on hire purchase

Leasing is a way of acquiring assets by making regular payments, but without buying them outright. Hire purchase is a similar way of paying for assets, but you end up owning them. See our guide on how to decide whether to lease or buy assets.

Inject new capital

This could be new share capital, a long-term loan, or the sale of shares to a new equity partner.

The downside of this is that you may have to give up some control of the business, or pay a high rate of interest. See our guides on equity finance and bank finance.

Reduce the money taken out

This might not be a welcome suggestion but perhaps it should be considered. It may mean not paying dividends. If your business is a partnership or you are a sole trader, it may mean taking less salary, fees or benefits.

Cut costs and be more efficient

This is easy advice to give and you are probably already doing what you can, but if you can cut costs further, it should increase your cashflow and cut the risk of overtrading. It should also increase profits. See our guide on cashflow management: the basics.

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An example of overtrading

Emily’s business is three years old. Her annual turnover is £200,000 and her annual profit is £18,000. She operates with a bank overdraft of up to £25,000. Her working capital is sufficient to steadily expand the business.

Emily succeeds in winning a contract to supply Business A. The order is for £40,000 a month for two years. She will be paid 75 days after delivery.

She rings her suppliers. She orders everything that she will need to fulfil the contract in the first few months. She tells them all to deliver everything as soon as possible.

The first month

Things go very well. All the suppliers start delivering as promised. The only problem is that she is short of space.

The second month

Things still look good. She has made the first delivery to Business A. She increases her overdraft.

The third month

Emily has problems. She has made more deliveries to Business A but her overdraft is at the limit. She is getting calls from unpaid suppliers.

The fourth month

Emily has a crisis. She cannot pay all her suppliers. Some have stopped delivering and are threatening legal action. She thinks that she will be fine because she is still supplying Business A.

The fifth month

Her overdraft is £4,000 over the limit. Three suppliers start legal action. The bank refuses to pay any more cheques. But her first payment from Business A arrives on time.

The sixth month

The next Business A payment does not arrive on the due day. She cannot fulfil any more orders. The bank demands that the overdraft be repaid within seven days.

Emily closes the business and blames the bank. However, if timings and payments of deliveries from suppliers and to customers had been negotiated and regulated more successfully beforehand and at the start, the closure may have been avoided.

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An example of avoiding overtrading

Karen’s business is three years old. Her annual turnover is £200,000 and her annual profit is £18,000. She operates with a bank overdraft of up to £25,000. Her working capital is sufficient for her to steadily expand the business.

Karen wins a contract to supply Business B. The order is for £40,000 a month for two years. She will be paid 75 days after delivery.

Karen’s plan

Karen asks Business B to pay her in 45 days in return for a small reduction in the contract price. Business B agrees.

Karen rings her suppliers to place the orders. She orders carefully and schedules the delivery dates so that her payments are delayed for as long as possible.

She asks her biggest supplier to wait an extra 15 days for payment. In view of the bigger orders they agree.

She decides to devote more time to persuading all her other customers to pay on time.

She decides not to take any money out of the business for three months. She has savings and can manage to do this.

She draws up an impressive written plan and presents it to the bank. The bank agrees to increase the overdraft limit to £50,000.

The contingency plan

Karen finds out about factoring. She does not intend to do it but she works out how much money she could obtain if she did. See our guide on factoring and invoice discounting: the basics.

What happened?

Due to the careful management of her cash, the plan worked brilliantly. She did not need to factor her debts because she got the balance just right.

Business B was pleased and after six months increased the size of the order. Karen considered the risks of being too dependent on just one customer and began to look for new business opportunities to complement her existing business.

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CASE STUDY

Here’s how I avoided the pitfalls of overtrading

Rapid Technologies is one of the UK’s fastest-growing IT and communications companies. Strong growth in recent years raised a number of financial and strategic challenges. Managing director Mark Stevens explains how careful management helped the company steer clear of overtrading.

What I did

Monitor and assess cash needs

“Our computer sales and support business was growing rapidly, plus we were diversifying into new areas like education and internet services.

“Fortunately, we had good purchasing and general financial controls in place, so we could keep a close eye on sales, cash, assets, liabilities, creditors and debtors. That was paramount in helping us avoid overtrading.

“Reviewing the figures, we realised that while sales calls were flooding in, we were in danger of not having the people or financial resources to fulfil orders or provide ongoing service. Profit margins were also being squeezed as we cut prices to compete with new competitors.

“We also foresaw problems with importing stock. As sales grew, we had to import more machines, often on the basis of letters of credit – a documentary credit raised by the importer’s bank and confirmed by the bank of the exporting company. Letters of credit (LCs) offer assurance to the exporter that their invoices will be paid when certain documents, such as signed delivery notes, are submitted to them. However banks treat LCs as a commitment to pay and deduct the outstanding amount from the importer’s bank facilities. We could see that our letters of credit would soon eat up our entire overdraft facility, further reducing our working capital.”

Take action

“We cut costs where we could and looked into invoice discounting as a temporary measure. We also negotiated better payment terms with suppliers and tightened up our cash collection procedures.

“We needed to inject some capital too, but like most owner-operators we didn’t have a lot of cash sitting in the bank and we didn’t generate enough cashflow to finance growth from monthly profits. We didn’t want to introduce new equity partners, as this would reduce control. In agreement with the bank, we borrowed money from our self-managed pension fund with a detailed plan for repayment, which we have subsequently achieved.”

Rethink and reorganise

“Once we had the threat to our cash under control, we looked at the bigger picture. Our close call with overtrading pushed us to rethink and reorganise.

“We closed the retail area of the business and opened a new telesales channel targeting niche markets, giving us more control over the type of customer we took on. We also refocused on emerging technologies and limited hardware and software sales to larger contracts that would be more cost-effective to support.”

What I’d do differently

Structure the business for growth sooner

“The steps we took have helped us to sustain growth at an average 25 per cent a year for the last five years. However, given our time again, we would put better forecasting processes in place to match cash requirements to sales forecasts at a much earlier stage.”

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