Chapter 21 Last Word—Be Wary of Overtrading – The Rainmaker


Last Word—Be Wary of Overtrading

As a precursor remark to this final chapter, be wary that chasing profits can lead to overtrading, which can have similar negative results as undertrading.

How Is the Term Overtrading Defined?

Overtrading is simply the rapid rise in sales without enough cash flow and capital to fund the increased trading. This is risky and a problem because you may run out of working capital and consequently place your company at risk of sequestration. Remember that banks use ratios to measure your risk exposure, and these have been reviewed in this book.

So, how do you know if you are overtrading, and what can you do about it?

As a starting point, overtrading occurs when any of the following occurs:

There is a rapid rise in sales without a commensurate rise in working capital.

Management use fixed assets as collateral to raise additional debt or they sell fixed assets to obtain cash.

Debtors and stock are increased to sustain the growing level of sales.

The foregoing results in liquidity ratios getting worseto a level of becoming a problem.

Consequently, ratios can be used to prevent overtrading.

Current Ratio = current assets divided by current liabilities. This is a measure of how much of total current assets are financed by current liabilities. Safe ratios tend to depend on the industry, but a general rule of thumb is that a ratio of 2:1 or greater is considered a safe measure.

Quick Ratio = current assets less inventory and divided by current liabilities. This is a measure of how well current liabilities are covered by liquid assets. A ratio of 1:1 means that you can meet existing liabilities when they are due for payment.

Payable days: Your cash position is getting worse if payable days are getting longer.

Danger Signs of Overtrading

Danger sign 1. You need to increase your overdraft to pay variable costs: If you don’t have the cash resources to meet these costs, it could lead to banks and other funders withdrawing loans. This tends to become a multiplier effect. If one bank withdraws a loan, many will follow.

Danger sign 2. Profit margins are low: A substantial rise in sales often results in prices being driven down as competition increases. This will drive down profit margins and add to your worsening cash-flow position. This will occur if you cannot decrease costs of sales.

Danger sign 3. Customers and Suppliers. Without regular payment from customers you may not be able to pay your suppliers, which could be the final straw for your business if you have a cash flow that is already under pressure.

Solution to Overtrading?

Convert short-term debt to long-term financing, giving you some time relief.

Finance working capital with short-term finance.

Final Rainmaker Observation: From an economic perspective, it is high-growth companies that are helping reduce unemployment. It would be pointless to see employment turning into retrenchments because you are unable to balance growth with cash-flow management. It is simple. Your bank balance tells it all. If your balance falls, take remedial action. Funders won’t ask you to do that.