Financial Management

Tutorial 9
Question 1
(a) Define the terms ‘over-capitalisation’ and ‘overtrading’.
• Over-capitalisation is the reverse of overtrading. It means keeping funds idle

and not using them properly. This is due to the under employment of assets of

the business, which leads to the fall of sales. Instead of facing a liquidity

problem, the amount of capital is too large in relation to the volume of business.

• Overtrading is a situation in which a company is growing its sales faster than it

can finance them. This usually leads to enormous accounts payable and

accounts receivable and a lack of working capital to finance operations. The

companies are often unable to raise long-term capital and thus tend to rely

more heavily on short-term sources such as overdraft and trade creditors.

(b) Briefly describe the symptoms of overtrading. Conclude
whether Rant Ltd is overtrading, giving reasons for your
conclusion.

• The symptoms of overtrading are:

i. sharp and rapid increases in the volume of sales.
ii. Falling profit margins despite increased sales .
iii. Debtor, creditor and stock turnover ratios deteriorate.
iv. Short-term funding, especially in the form of overdrafts, is relied
on more and more.
Rant Ltd
• Turnover has increased by 250% and fixed assets have increased
by 75%.
• The bank overdraft limit of $3 million has been exceeded on five
occasions in the last year, indicating a rapid increase in borrowing.
• None of the current shareholders are in a position to inject new
capital into the company neither do they wish to issue new shares
outside the current group of shareholders at present.
• Some preliminary analysis has revealed that debtors are
increasing rapidly and liquidity ratio have decreased.
• Therefore, we can conclude that Rant Ltd is overtrading.
(c) Explain the FOUR(4) main types or costs
associated with stock management.
I. Holding cost is the cost of holding stocks for examples
interest cost of investment, storage cost, administrative and
staff cost, insurance cost.
II. Ordering cost is the cost incurred each time a batch of
inventory is ordered. Such cost will include order
administration, loss of quantity discounts and cost of
checking inventory after delivery.
III. Stock-out cost is the cost of running out of inventory. These
may include loss of a sale and results in loss of contribution
that would have been earned from the sale.
IV. Purchase cost of the inventory.