What is Overtrading?

In the context of cash flow, overtrading refers to a situation where a business is expanding its operations too rapidly or taking on more sales and customers than it can effectively support with its available cash flow. It sounds like a good problem to have but it can be fatal.

Overtrading occurs when the rate at which the business is generating revenue and conducting transactions exceeds its ability to collect payments from customers or raise sufficient funds to cover its operating expenses and financial obligations.

Overtrading can create significant cash flow problems for a business, even if it appears to be experiencing strong growth. This is one of the reasons banks and lenders use metrics such as Net Cash Flow From Operations.

There is an acceptance that more businesses fail coming out of a recession, one of those reasons is that cash reserves are used up, access to capital restricted and growth cannot be financed.

What are the signs of overtrading?

Some common signs of overtrading in relation to cash flow include:

Working Capital Shortages

The business may struggle to finance its day-to-day operations because it lacks sufficient working capital. This can lead to delays in paying suppliers, inability to meet payroll, and difficulty in maintaining stock levels.

Late Payment of Creditors

Overtrading often results in delayed payments to suppliers and creditors, which can harm the business’s relationships with its vendors and affect its creditworthiness, leading to more restricted terms, less credit and an ever diminishing cycle.

High Levels of Debt

The business may rely heavily on borrowing to finance its expansion, leading to an accumulation of debt that becomes challenging to afford. The business may also see cash flow facilities not expanding in line with growth (which is where invoice finance can be beneficial)

Cash Flow Gaps

There may be significant gaps between the timing of cash inflows (e.g., customer payments, sales, debtors) and cash outflows (e.g., payments to suppliers and other creditors), leading to cash flow shortages.

Decline in Profit Margins

While revenue may be increasing, overtrading can result in lower profit margins due to increased costs associated with rapid expansion. Businesses will reduce prices to bring in more sales and generate cash because they can’t finance growth.

Inability to Invest in Growth

Paradoxically, overtrading can hinder long-term growth as the business may be too preoccupied with short-term cash flow challenges to invest in expansion opportunities. A case of dealing with the issue at hand and not forward planning.

Overtrading Summary

It’s important for businesses to strike a balance between growth and cash flow management. Proper financial planning, forecasting, and monitoring are essential to avoid overtrading. Too often a business will use sales, profit and margin as key metrics and forget about cash.

Implementing effective credit control measures (including invoice finance), managing stock, negotiating favorable payment terms with suppliers, and maintaining adequate cash reserves can help businesses avoid cash flow problems associated with overtrading. There is a common good practice that say to raise finance when you don’t need it for when you do. It remains the case. Finance is cheaper and easier to access when trading is good.

If you have concerns with overtrading or want to finance cash flow, talk about your options or chat things through then get in touch.

By Dave Farmer