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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
serious, even fatal to an organisation, so it's worth taking time to understand how to prevent
This guide explains what overtrading is, how it can occur and how to avoid it.
What is overtrading?
Overtrading takes place when a business accepts work and tries to complete it, but finds that
fulfilment requires greater resources of people, working capital or net assets than are
available. This is often caused by unforeseen events such as manufacture or delivery taking
Working capital is the difference between current assets and current liabilities. In the
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
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
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
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
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 should help
you to:
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
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 suppliers you can trust if it is to
work.
It is often helpful to compare the assets and liabilities of your business. You will also find it
useful to forecast 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-
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
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.
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
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
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
Read information on financial ratio analysis and gearing on the Biz/ed website -
In order to assess your cash needs accurately you need to use accurate, up-to-date figures or,
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
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
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
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
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
Read information on financial ratio analysis on the Biz/ed website - Opens in a new
window.
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
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
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.
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 CHAPS Clearing Company website - Opens in
a new window.
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 debt factoring and
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,
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 preventing late payment.
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 recovering late payments and use our interactive tool to
One way you can help prevent overtrading is by keeping a tight control of the money you have
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
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 loans and overdrafts.
paying dividends. If it is a partnership or you are a sole trader, it may mean taking less salary,
fees or benefits.
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.
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
Emily succeeds in winning a contract to supply Business A. The order is for £40,000 a month
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.
Things go very well. All the suppliers start delivering as promised. The only problem is that
Things still look good. She has made the first delivery to Business A. She increases her
overdraft.
Emily has problems. She has made more deliveries to Business A but her overdraft is at the
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.
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 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.
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
Karen wins a contract to supply Business B. The order is for £40,000 a month for two years.
Karen's plan
Karen asks Business B to pay her in 45 days in return for a small reduction in the contract
Karen rings her suppliers to place the orders. She orders carefully and schedules the delivery
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
She draws up an impressive written plan and presents it to the bank. The bank agrees to
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 debt factoring and invoice
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
Mark Stevens
Rapid Technologies - Opens in a new window
"Make the most of reporting tools to constantly monitor your sales and cash position."
"Always have a 'Plan B' - trading conditions can change quickly."
"Don't succumb to 'knee-jerk' reactions. It often takes time to see the benefits of
measures you put in place."
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
"Our computer sales and support business was growing rapidly, plus we were diversifying into
"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
"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
"Once we had the threat to our cash under control, we looked at the bigger picture. Our close
"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
"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
Manage your personal list of starting-up tasks with our Business start-up organiser
Use our interactive tool to assess how well your business is performing
Use our interactive tool to find out how you can recover unpaid debts
Use our interactive tool to find and secure the right finance for your business needs
Equity finance
B5230B7B/live/cid_improving_cashflow_using_credit_mgm_Apr09.pdf.pdf
http://www1.learndirect-business.com/?target=xpc.asp?
course_id=5561%26wbt_type=course
http://www.bized.co.uk/compfact/ratios/index.htm
http://www.bacs.co.uk/BACS/Businesses/SME/Pages/default.aspx
Factor and invoice discounting information on the Asset Based Finance Association
website
http://www.abfa.org.uk/public/faq.asp