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Avoid the problems of overtrading

Avoid the problems of overtrading

Introduction
Overtrading is an imbalance between the orders a business accepts and the means it has to fulfil them. It happens when a business takes on orders, but does not have enough current assets, or working capital, to meet these demands. This is particularly common in young, rapidly expanding businesses. It can be extremely serious, even fatal to the business, so it's worth taking time to understand how to prevent it happening to your business. This guide explains how overtrading can occur and shows you how to avoid the problem.

What is overtrading?
Overtrading takes place when a business accepts orders, and tries to fulfil them at a level that cannot be supported by its working capital or net current assets. This means that it does not have enough cash and cannot obtain enough cash quickly.

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.

Current assets
Stock Debtors (owing by customers) TOTAL ASSETS

66,000 37,000 103,000

Current liabilities
Creditors (owing to suppliers) Bank overdraft TOTAL LIABILITIES Net current assets 71,000 29,000 100,000 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 recently started businesses and to rapidly expanding businesses. As you may have discovered, cash often has to leave the business before more cash comes into the business. Wages and salaries are usually payable weekly or monthly. Other expenses may be payable very quickly. You may pay suppliers on credit, but then customers may also pay you on credit. It doesn't take much for the balance to go wrong. It is possible to run out of cash even if your customers pay cash and do not have credit accounts. It could happen, for example, if you have to pay suppliers quickly and hold stock for a long time. What matters is the amount of working capital and the timing of cash coming in and going out.

Matching sales and production cycles

There can be many causes and contributory factors, but 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 stocks for a shorter period and speed up the manufacturing process.

Just-in-time
Just-in-time techniques (JITs) may be of some help. As the name suggests, this is where goods and materials are delivered just in time for you to use them. JITs should help you to:

 shorten the cycle reduce the period that you hold stock reduce the need for working capital
However, JITs may not be easy to achieve. 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, JITs often work 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. A potential disadvantage of JITs is that you are cutting down your margin of safety. You will need good systems, good planning and suppliers you can trust in place if it is to work. Download a factsheet about just-in-time production from the Manufacturing Advisory Service website (PDF).

Assessing your cash needs: assets and liabilities

It is often helpful to compare the assets and liabilities of your business, using up-to-date figures. The same comparisons based on forecast figures can be useful as well. The following are some of the ratios that are often monitored to avoid overtrading. They may help you understand your own business' cash needs.

Working capital and quick ratio

Working capital is the difference between current assets and current liabilities. The safest position to be in is clearly 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 left out of the current assets total entirely. Only investments, money in the bank, cash and money owing by customers are counted. Stock may take some time to turn into cash. This is why it is left out. You can, to some extent at least, be confident if your business does well with the quick ratio test.

Gearing
This is the percentage of money borrowed from the bank compared to 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. This is 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 at the Biz/ed website.

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. Two other useful comparisons are: Debtor days ratio: this shows how long, on average, your customers are taking 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. Read information on financial ratio analysis at the Biz/ed website.

Avoid the problems of overtrading: debts

Overtrading is potentially damaging, so it is wise to avoid it. One way of achieving this is by ensuring your debts are paid on time. You could try to renegotiate payment terms, or tell customers that new terms will apply for future orders. Customers may object. Much will depend on the strength or weakness of your competitive position. Good credit control is essential and most businesses have scope to manage and recover debt more efficiently, which is always a good idea.

Offer discounts for prompt payment

This can be very effective but there are disadvantages - it can be expensive and it has to be policed.

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.

Factor your debts

Factoring your debts can release a lot of money.

Pay your suppliers more slowly

You could try to negotiate different payment terms or you could just take longer to pay. However, this may be considered unethical. Suppliers may refuse to supply you. You may have to give them something in return such as a promise of regular orders.

You could try to improve your stock throughput

This means turning over your stock more quickly, holding stock (and raw materials) for a shorter time. If you can achieve faster stock turnover, there should be worthwhile benefits. There will be a shorter interval between the time that you pay your suppliers and the time that your customers pay you for the same goods. There are many other solutions. Find information on paying suppliers on the Better Payment Practice Campaign website.

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

This is instead of outright purchase.

Buy your fixed assets on hire purchase

This has a similar effect to leasing, but you finish up owning the assets.

Inject new capital

This could be new share capital, a long-term loan, or it could be an injection of capital by 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.

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 it is a partnership or you are a sole trader, it may mean taking lower drawings.

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.

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.

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.

What happened?
Due to her careful resourcing of 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.

Related web sites you might find useful

Download guidance on cashflow and overtrading from the Chartered Institute of Management Accountants website (PDF) http://www.cimaglobal.com/ Read information on financial ratio analysis at the Biz/ed website http://www.bized.ac.uk/compfact/ratios/index.htm
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