What is “overtrading” and how to avoid it

As we enter a new year, business owners know there are various challenges in the market, but many management teams are also experiencing lots of opportunities and their company has never been busier!

In many cases, turnover is high and the business is struggling to recruit enough staff and obtain sufficient materials to fulfil the demand for orders.  

Official data is starting to reflect this optimism as according to ONS data in December, 19.7% of businesses thought their performance would increase over the next 12 months.

However, as much as growth and increased profits sounds positive, there are short-term cashflow considerations to be aware of. 

This guide discusses what “Overtrading” is, the implications of it and how to prevent it.

What is overtrading?

Overtrading occurs where a business grows too fast for the resources it has to support it.  

What are the implications of overtrading?

There are three main implications and both can result in insolvency, despite the business appearing to grow and being profitable.  

1. Running out of cash - the most common result of overtrading is not being able to pay key costs such as wages, rent, suppliers or HMRC.

Despite the business having a healthy order book, these sales are not able to be fulfilled because the company cannot afford to make the goods or provide the service. 

Those creditors could force the company to enter into insolvency if their payments are not being made.  

Most businesses collapse due to lack of access to cashflow, rather than being loss-making.  The company just runs out of time as their creditors run out of patience.

2. Not tracking true costs - often if the company is very busy and invoicing substantial amounts quickly, the financial information may be lagging behind. 

Job costing, which in turn should determine sales prices, may be inaccurate and therefore the company may be making less profits than they originally thought.  

If the management team doesn’t monitor this data on a regular basis, by the time the true picture is known, the company may have incurred losses.  

Longer term this will result in the business not being able to continue. 

3. Lowering quality - if the company is struggling for cashflow, it will be important to invoice as fast as possible.  This may result in quality standards becoming stretched as production or delivery is rushed. 

Longer term this could have an impact on the company’s reputation and profitability, especially if some items are returned to the business for refunds. 

The signs of overtrading

These are some of the signs that a business may be overtrading:

1. Always running out of cash and struggling to make payments to employees, HMRC, lenders or suppliers.  This may be shown by the company always using its maximum overdraft or invoice finance facility.

2. Credit score decreasing as payment performance starts to decline

3.  High sales growth but decreasing gross profits and net profit margins

4. Increasing number of complaints from customers as quality decreases

5. High staff turnover as employees do not enjoy working in the continual high stress environment

If any of these sound familiar, then steps should be taken to avoid the situation becoming worse. 

Preventing overtrading

Running a growing business is a positive experience if the risk of overtrading is managed. 

This would include:

1. Ensuring that all costs are up to date for materials, wages, overheads and other fixed costs such as recruitment agency fees, machinery downtime, higher insurance premiums etc.  This will allow management teams to set prices effectively so that true profits are being made as expected.

2. Maximise internal working capital.  By monitoring the company’s own credit score, businesses can ensure that they achieve the most preferential levels of supplier credit. Tracking other company’s credit scores will provide information to set credit control procedures and protect supply chains.  
   Management teams should communicate regularly with their customers and suppliers to maintain transparent trading relationships. 

3. Managing daily, weekly and monthly cashflow with the use of projections.  Having up to date financial information will ensure that the business does not run out of cash unexpectedly. Where a cashflow shortfall is projected, management will have time to arrange adequate lending facilities to bridge that gap. 

4. Where capacity is running close to maximum, businesses should be brave enough to either turn away work or increase their sales prices to ensure even higher levels of profitability. 

5. Reinvest profits as part of the longer term strategy.  Extracting all the profits as dividends or remuneration will reduce available resources.  

Once a business has enjoyed a period of growth, it should have a financial cushion there to help build upon even more growth in the future.