The dangers of overtrading

It might seem logical that the more business you have, and the larger the orders you can secure, the better position your business is in. But this is not always the case. It is possible to try to grow too big, too fast, and run the risk of overtrading.

What is overtrading?

Overtrading occurs when a company expands operations faster than it can afford to. The business enters a negative financial cycle because it does not have enough working capital to pay for the extra machinery, equipment, goods, or staff it will need to ramp up production, while having to wait several months before the money from the new contracts or sales come in.

This leads to liquidity problems for the business, which unless carefully managed, can result in the need to close the business.

How does overtrading happen?

  • Business start-ups in their first few years of trading are most susceptible, but overtrading can happen to any business that scales up its operations.
  • A typical example would be a small manufacturing or service company that gets a bigger order or tender. To meet the order, they need bigger premises, more staff, and possibly more equipment. They might also need to place larger orders with suppliers.
  • All this costs money, and often the company will need to pay a significant amount before receiving income from the new order or tender. If the company has not worked out a detailed cash flow forecast and made plans to meet these needs, it might need to borrow money in a hurry.

How to avoid overtrading

The easiest way to avoid overtrading is to approach any opportunities to grow your business with due diligence and caution. It is important to make sure your business will remain financially sustainable in the short and long term. Check the affordability and put measures in place to ensure your business does not run out of money, leaving you unable to pay debts when they fall due.

  • Prepare a detailed cash flow forecast. This will tell you whether you have enough money, or how much additional cash you’ll need, to finance the expansion or undertake the project. It will also help ensure you’ve remembered to account for all expenses.
  • Implement a tighter stock control policy. Rather than ordering stock or raw materials well in advance and having your working capital tied up in stock, aim to order stock and raw materials just before you need them, to free up capital for your expansion plans.
  • Chase payment as soon as debts fall due and plan to offer discounts and incentives for early payment, to ease the pressure on your cash flow and avoid the problems of overtrading.
  • Remember not to focus on one big customer to the exclusion of others. They could experience financial problems, or decide to take their business elsewhere. Or they could simply pay you late, leaving your business exposed to an unexpected cash flow crisis.

Some solutions to overtrading

Consider the following options to improve liquidity and cash flow in your business, or as part of your contingency plan should things not turn out as well as you expected. You’ll need to investigate the advantages and disadvantages of each option for your business, and weigh these against any liquidity benefits.

  • Lease any equipment you need, rather than buying for cash or on terms. With leasing, the amount you’ll pay is likely to be less than if you buy an asset on hire purchase.
  • Use invoice discounting or factoring to boost your working capital quickly and ease your administrative burden. These services pay you a certain percentage (usually around 75%) of the money people owe you, less their fee, once invoices are paid by your customers.
  • Outsource some of the work you’re not yet equipped to do, or form a consortium with other businesses. This does mean you’ll probably have to share the profit, but it also means you’ll be exposed to less risk of overtrading.
  • Look for ways to increase efficiencies in your operations. If you can run more efficiently, you’ll spend less, which means less pressure on your cash flow. Be on the lookout for ways to work faster or more productively.
  • If you’re facing liquidity issues, or anticipating them, consider renegotiating your terms with customers or suppliers. You should also be able to negotiate longer payment terms or better prices with your suppliers as you increase the amount you buy from them.

Next Steps

  • Stop and look carefully at all the costs and financial implications involved with taking on a large new customer or order before you rush into the deal.
  • Prepare an accurate cash flow forecast to gauge the likely effect on your short- and long-term liquidity.
  • Renegotiate terms with customers and suppliers if required, and put contingency plans in place in case your business’s liquidity comes under threat.
  • Keep accurate financial records so you can update your cash flow forecasts and actively manage your business to avoid an unexpected liquidity crunch.

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