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Overtrading

Overtrading
Overtrading is sometimes referred to as under capitalisation; it is a term that is
used to refer to a situation where an organisation is having increasing trading or
business activities, especially where trading is made on credit sales without
sufficient funds (capital) to support such increasing trading activities.
This is where company has increasing sales volume, usually with lots of
customers buying on credit (sometimes with more extended credit limits and
periods than is often offered by its competitors and above the industry average),
but the prolonged credit sales period (credit limit) means that company may not
have immediate or sufficient funds from its credit sales and may run the risk of
not having sufficient funds to meet its trading activities and possibly be faced with
liquidation.
This is often a big problem for small medium enterprise (SME) who are caught up
in the excitement / thrill of increasing sales and business at the inception of
business, such that if they are caught up with poor (and inadequate)
debtor/receivable management policies, they run the risk of overtrading.
Overtrading is often attributed to insufficient funds to meet organisations
operating activities, or poor/inefficient management policies.
When company has increasing sales, it is a good thing, especially if such
increasing sales are on cash, or even if it is on credit, but customers pay
promptly within the credit period, but where customers take increasing credit
period (paying in 68 days instead of 30 days, that is involuntary trade credit) it
may affect the cash flow of the company and may lead into liquidity problems and
possibly bankruptcy, as a result of such overtrading.

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Overtrading

Indicators of overtrading
Although one cannot say for sure whether a company is overtrading or not, just
by looking at its financial statements, and or performing simple ratio analysis of
the organisations financial statements, the financial statement is still one of the
most useful external source of information that may be available to an external
stakeholder in making a decision as to whether a company may be overtrading or
not.
Some of the indicators of overtrading are:
Increasing credit sales volume
Extended credit sales period taken by customers, than industry average
Increasing sales without corresponding increase in profit
Increasing inventory days, excessive investment in inventory, probably
with no immediate need
Increasing and excessive reliance on trade payables as a source of funds
for working capital needs
Extended trade payables periods, sometime the company takes
involuntary trade payables period.
Lack of cash in hand or at bank, hence excessive reliance on bank
overdraft as a major source of finance for working capital activities
Increasing working capital cycle
Increasing sales without corresponding increase in long-term sources of
capital in the form of bonds and / or equity
Decrease in the companys liquidity ratios such as current ratio and quick
ratio
Below are some ratios that can be computed to investigate whether a
company is overtrading or not:
Stock (inventory) days
Debtor (trade receivable) days
Creditor (trade payable) days

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Overtrading

Current ratio
Quick ratio
Gross profit margin
Net profit margin
Return on capital employed
Percentage change in individual items that constitute the financial statements,
especially the profitability and liquidity measures in the financial statement; such
as:
Percentage change in:
Sales; Cost of sales; Gross profit; Net profit; Inventory; Receivables; Payables;
Bank overdraft; Bonds and Equity.
Possible remedies of overtrading
The two main causes of overtrading are:
(i)

Insufficient funds for increasing credit sale

(ii)

Poor management practices / inefficient management

To remedy overtrading, the main causes of it must be identified and measures


put in place to reverse, and or reduce its reoccurrence.
This may include proper management practises, where management are
properly trained and know the effects of such poor management of working
capital that are in place.
Other remedies are:
Efficient working capital management such as;
Efficient inventory controls (EOQ, JIT, maximum stock levels, Re-order
level, minimum stock level)
Efficient receivable management (checking credit worthiness of
customers, prompt invoicing, use of factor services, invoice discounting
etc . . .)

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Overtrading

Proper cash management arranging for different sources of finance, to


overcome come of the insufficient funding problems, such source of funds
may include, using leasing, hire purchase, short-to-medium-term loans,
bank overdraft.
In the long-term, the company may consider raising more equity finance
by obtaining listing on the stock market, either on the AIM, or the main
market etc, . . .
Conclusion
Overtrading can be a very big problem for companies, especially SME. Where
such companies have increasing credit sales, growing business, but due to lack
of funds, lack of assets to use as security for future loans, they find themselves
being faced with such difficult situation.
To protect against such occurrence, companies need to be aware of overtrading,
its indicators and then put in place adequate measures to avoid it occurring or
reduce the probability of it occurring.
Your comments, contributions, articles etc on the above article and any other
accounting, business, finance and related issues is welcome. You can send us a
mail on info@warmah.com
Written by;
William Armah
Fellow; warmah.com

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