What is overtrading?
Overtrading is when a business takes on work and tries to complete the orders but finds that fulfilment requires greater cash, or further resources than are available.
The reasons could be many, and can be unforeseen, rather than just attributing it to an overzealous sales team.
Manufacturing or delivery could take longer than anticipated resulting in cashflow being impaired, or customers making late payments. Prices of stock or machinery could suddenly rise which leads to over spending by the business.
It is very common in young businesses who will take on more risk as their desire to establish their business quickly is strong. They will often take on business regardless, rather than turn it away.
For Example:
Your business is selling blue widgets and it suddenly turns out that everyone wants blue widgets. It sounds like a dream come true, but it might not be particularly good news for your business, especially for a new business. The dream could suddenly turn into a nightmare if you don’t have the necessary funds to cover the costs of the sales.
Cashflow problems are one of the biggest challenges facing businesses. The timescale from a customer placing an order to them actually paying for the goods can be too lengthy. We can use our blue widget scenario to illustrate this.
Say you had £6,000 in your bank and a customer places an order for 100 widgets at £100 per widget. Great, you think that will be £10,000 but it costs you £60 per widget to manufacture. You are still making £4,000 profit, but it takes you three weeks’ to deliver the product and the client has 30 days’ to pay their invoice.
The next day a different customer places another order for another 100 blue widgets. Your bank account has been cleared because you already paid for yesterday’s orders.
At this point you are probably overtrading and it’s unlikely that your supplier will give you extended credit terms, especially if you are a young company with little purchasing history. So, you have to either turn the order down and risk losing out to a competitor, or push the company into debt.
Here are some warning signs that you may be overtrading:
Borrowing money every month
Using an overdraft occasionally is fine and using a business loan for a long-term capital project (for example, making improvements to your business premises) is acceptable, but when you need to borrow cash regularly to pay suppliers, it is a dangerous sign. Beware of offering personal guarantees for finance. It may seem fine obtaining finance on these terms if you think it is just a temporary solution, but businesses can regularly produce unexpected costs. Not being able to repay your debts could lead you to losing your home.
Your profit margins are too low
A competitive world means clients are very price sensitive. New entrants to business will often undercut competitors to try and establish themselves in the market. The result is low profit margins, which impact an already shaky cashflow.
Increasing late payments
If you already have a weak cashflow any changes in market conditions will have a bigger impact. In tough times the chances are your customers are also finding it tough and it will take longer and longer to settle your invoices. This could have a disastrous effect on cash flow leaving you in an even further vulnerable position. It is essential that all your customers are clear what your payment terms are, and that you regularly chase payment when they are overdue.
Difficulty in obtaining supplies
Key suppliers in a business who have been trading for a long time know when things are not quite right. Whilst they will be delighted by the orders that you are placing, they will become nervous if you suddenly start making late payments. They could reduce your credit, insist on proforma invoices, or worse still, refuse to take the order. If you have problems with suppliers, or can see difficulties on the horizon, talk with them as soon as possible. Keeping communication channels open could help your supplier be more favourable if you can reassure them early on.
If you are, or suspect that you are overtrading, taking advice early on is essential to avoid further debt – which you may find your company will not be able to return from. Speaking to business recovery specialists means that you could find solutions to your problems, or at least provide strategies for damage limitation.
If you or your clients have financial difficulties, please call 0808 168 7540 to see how we can help.