In business, growing revenue and profit is usually seen as something positive.
But there is a downside to growth called overtrading.
This occurs when a business expands quickly and does not have the finance in place to fund growth. The result is a lack of working capital to cover day-to-day expenses while sales are growing.
What is overtrading?
To understand how rapid growth can become a problem, we’ll look at a hypothetical example of a company called Growco which produces a product called super-widgets. Due to the popularity of super-widgets, sales are growing at a rapid rate. In the process of making products, more raw materials need to be purchased, factory staff need to be paid and other expenses are incurred.
In addition, many other day-to-day expenses need to be met. After the super-widgets are sold and delivered, customers receive 30-day invoices, some of which are paid late after 60 or even 90 days.
As Growco’s sales increase, the shortfall in cash required to pay for producing more super-widgets grows. This is due to the lag time between producing products and receiving revenue from sales. When new orders come in, Growco may not have sufficient funds to purchase materials or pay staff.
When business growth exceeds the finance available, overtrading can quickly damage a business because it does not have the working capital required to fulfil growing demand.
The dangers of growing too quickly
This scenario is common when a business expands rapidly or wins a large supply contract without having the right finance in place. For example, a packaged foods producer may secure a contract with a major supermarket chain. While this appears to be a major opportunity, the need for working capital increases immediately while payment terms may stretch out to 60–90 days.
The same issue can occur within service businesses. Staff wages and operating expenses increase well before payment for services is received. While sales continue growing, the business can struggle to fund the additional work.
To overcome working capital shortages, businesses often borrow funds. However, choosing the wrong funding structure can create a negative cycle where increasing interest expenses reduce profitability, which further reduces working capital and creates an ongoing dependence on borrowing.
This is why understanding the return on investment of a business loan is important before taking on additional debt.
Warning signs of overtrading
If a business is growing but constantly short of cash, it may be suffering from overtrading. Warning signs include:
- Insufficient cash to cover day-to-day operating expenses.
- Low or reducing margins, particularly in competitive markets.
- Difficulty paying key suppliers, which can eventually affect supply continuity.
Several financial ratios can be used to better understand your cash flow position.
For example, the working capital ratio (current assets ÷ current liabilities) measures whether a business has enough current assets to pay current liabilities with an additional buffer. The higher the ratio, the stronger the position.
The liquidity ratio ((current assets – inventory) ÷ current liabilities) can also provide a clearer picture of short-term financial health. Companies with a quick ratio above 1 generally have enough liquidity to meet short-term obligations.
An accountant can help interpret these figures and explain what they mean for your business.
Steps for preventing overtrading
Fortunately, there are several steps that can help prevent or minimise overtrading:
- Managing receivables and getting paid sooner – staying on top of outstanding debts improves cash flow. Businesses may also consider discounts for prompt payment or deposits.
- Negotiating improved payment terms with suppliers.
- Reducing unnecessary costs and overheads.
- Monitoring and forecasting cash flow – regularly reviewing cash flow statements makes it easier to identify future shortfalls. Our guide on mastering cash flow provides additional tips.
- Using short-term finance when cash flow shortages occur. Our friendly Brokers can assist — enquire now.
Businesses experiencing ongoing cash shortages may also benefit from exploring business funding options or reviewing strategies for overcoming a cash flow crunch.
Business publications regularly publish stories about businesses that appeared successful on the surface but ultimately failed because growth outpaced their financial capacity. Knowing where your business stands and taking action early can prevent or minimise the effects of overtrading.
