Overtrading means planning an aggressive and overambitious growth plan. It results when a business undertakes trading activities more than the resources it possesses.
Overtrading is a working capital management problem and its causes and solutions also revolve around it. A business must fully understand the reasons for overtrading to create an effective plan to reduce its effects.
Let us discuss what is overtrading in working capital management and which steps a business can take to reduce it.
Overtrading – Definition
Overtrading refers to conducting more business than the working capital of the business can support it. It means growing faster without having adequate cash resources.
Overtrading is an accounting term that describes a working capital management issue. In simple terms, it is a scenario where the business is involved in more operating activities than it can support through working capital.
Overtrading may also refer to a stock exchange phenomenon where an investor is involved in excessive trading.
What is Overtrading in Working Capital Management?
When a business manages its working capital in a way that it does not arrange sufficient cash for the operating activities, it results in overtrading.
A common case of overtrading is observed when a business tries to increase sales. It books more orders than its operating capacity. Then, it tries to produce and sell more goods/services that it can support financially.
The end result of such poor execution of trading strategy results in overtrading. It means the working capital will lack the cash resources when and where needed by the business.
Apparently, higher operating activities and higher sales should encourage any business. However, due to poor working capital management strategies, a business fails to recover cash in time.
Some common scenarios can be extended credit terms with the buyers or due to unavailability of short-term financing facilities. For any reason, the end result of overtrading is cash flow and working capital management problems for the firm.
Causes of Overtrading
Broadly, when a business does not manage its working capital properly, it may end with the overtrading problem, along with the other challenges.
When a business intends to increase sales through increased operating activities, it needs to adjust its working capital forecasts. If it fails to do, it will result in lower cash flow and a negative working capital cycle for the firm.
Here are a few common causes of overtrading in working capital.
Insufficient Cash Flow
Lack of cash flow is the main cause of overtrading. Once a business decides to take on excessive sales orders, it must arrange sufficient cash resources.
Managing cash flow remains an integral part of working capital management. Insufficient cash flow means the business will have issues with inventory, human resources, and accounts payable as well.
Poor Cashflow Forecasting
Another key reason for overtrading is poor cash flow forecasting. Cashflow forecasting is an integral part of working capital management.
Cash requirements include inventory purchases, wages, salaries, equipment purchases, utilities, and so on. Forecasting accurate cash flow requirements can help avoid a lack of cash flow and overtrading as a result.
Longer Receivable Days
If a company cannot collect its dues from the customers, it cannot maintain liquidity. Longer receivable days or cycle means the customers will take longer to pay for the sales.
Eventually, a shorter receivable cycle will mean increased cash flow. Thus, the business will be able to fund its operations easily.
Shorter Payable Days
Payable cycle or days payable is another key metric in the managing working capital of a firm. The shorter the payable cycle the harder it gets for the business.
If a business maintains a shorter payable and longer receivable cycle, it will eventually face liquidity issues. That in turn will lead to overtrading as the business will not be able to fund its operations.
Lack of Short-term Financing
Young or highly leveraged businesses find it difficult to secure short-term financing. If they cannot finance their working capital through bank or trade financing, they cannot maintain a sufficient level of liquidity.
Effects of Overtrading on Working Capital Management
Overtrading can have adverse effects on working capital management. It will eventually hamper the progress of a business as well.
Here are a few major impacts of overtrading on a business and its working capital.
Negative Working Capital
Negative working capital means a business has more current liabilities than its current assets. It results from increased operational activities that result in higher inventory and operating costs overall.
Business Liquidity Issues
A negative working capital cycle means the business will soon run out of cash. If the business cannot maintain its short-term liquidity, it will lead to liquidity issues in the long run as well.
Both scenarios discussed above would compel any business to look for increased borrowings. With already stressed cash flows, the borrowing costs of a business will rise.
Also, in the long run, a high leverage level will mean higher interest rates.
Affected Supplier Relations
Overtrading would mean a business relies too heavily on its suppliers. The business would buy large inventory quantities are credit terms. If it fails to convert the inventory into cash, it cannot make timely payments to its suppliers.
Compromised Product Quality
In many cases, a business would look to produce more to fulfill its commitments. That can easily lead to compromised product quality. It can affect sales in the long run as well.
Another key impact of overtrading and its consequences can be demotivated staff. The business will look to maintain its operating activity levels that require higher inputs from the staff at all levels.
Eventually, if the business fails to achieve its targets, the staff will be demotivated.
How to Reduce Overtrading?
Overtrading does not manifest in a business overnight. It begins with overambitious planning and poor execution of the strategy.
The foremost point to reduce overtrading is to analyze and assess the situation thoroughly. Once a business understands its overtrading issues, it can develop a plan to overcome them.
Here are a few key tips on reducing overtrading.
Accurate Cashflow Forecasting
If a business intends to adopt an aggressive and ambitious growth strategy, it must match the planning with accurate cash flow forecasting.
Inaccurate cash flow forecasting would result in insufficient operating resources including inventory, human resources, and equipment.
Thus, improved and accurate cash flow forecasting plays an integral role in managing working capital and reducing the impact of overtrading.
Arrange a Financing Facility
A key element of planning and forecasting cash flow needs for a business is to arrange an overdraft or short-term bank loan facility.
Overdrafts and other short-term bank loans can help a business in managing its working capital needs. If the business has an adequate leverage level, it should opt for long-term bank loans. It can help reduce overtrading effects as well as manage working capital in the long run.
Negotiate Credit Terms with the Suppliers
Negotiations with suppliers for better credit terms can help a business solve working capital issues. That, in turn, will help it to reduce overtrading problems.
Once the suppliers allow for better credit terms, the business will be able to turn its inventory into cash frequently. It will ease the liquidity pressure and reduce a firm’s dependency on borrowed money as well.
Rearrange Supply Orders
An effective way of reducing overtrading impact is to rearrange the supply orders. A business can take supplier orders that take fewer days to complete. Alternatively, a business can complete the supplier orders that offer quick cash payments.
Outsource or Step Back
All the remedies discussed above can work if a business is facing overtrading issues that haven’t gone out of control.
A business should thoroughly evaluate and assess its operating capabilities. Even if it considers most of the steps listed above, it will not be able to reduce overtrading.
One way of reducing the overtrading problem is to outsource the orders or step back from the contracts legitimately.
Overtrading Vs Undercapitalization
Undercapitalization is a similar phenomenon as overtrading but for different reasons. Undercapitalization occurs when a business cannot fund its normal operating activities.
The end result in both situations is similar with the business struggling to maintain its working capital and liquidity.
The causes of undercapitalization are also similar to overtrading. Undercapitalization is mainly due to insufficient cash flows. Lower cash flows may be due to lower sales, longer receivable days, or a lack of credit facility for the business.
Undercapitalization is often observed in young and growing companies. These firms fail to anticipate their growth needs and operating costs accurately. These cost estimates include working capital costs as well as human resources to back ambitious growth plans.
The remedies to both overtrading and undercapitalization can work similarly. A business can improve its credit terms, increase operating efficiency, and obtain better financing facilities to manage its working capital.