Overtrading is a technical term in accounting that describes a situation where a company is expanding rapidly without sufficient cash resources to fund or finance the additional working capital needs and investment in new assets which the rapid growth demands. Business owners must ensure that they have sufficient resources to support their businesses’ growth ambitions. Business growth needs funding as it demands cash resources.
If the overtrading problem is not addressed in the short to medium term, the consequences may be serious to the business. The shortage of cash or working capital gap must be financed if the company is to avoid financial disaster such as insolvency or bankruptcy. Businesses fail because of lack of sales and they also fail from growth that is not underpinned by sufficient financial and working capital resources.
Solutions to Overtrading
The section below discusses some of the actions that a business with overtrading problems must do to rectify the situation:
- The business should negotiate and acquire an overdraft facility. The overdraft should then finance the additional working capital required by the growth. A prudent business should secure a bank overdraft to help it in difficult times or when unfavourable events crop up that require cash outlay on short notice.
- The business must negotiate favourable terms with its creditors so that it buys time by lengthening the time it pays its suppliers. The business should negotiate the terms so that it should be able to fund payments to creditors from receipts from the sales. If credit from suppliers is used efficiently and properly it can be a source of cheap credit for the business.
- The use of short-term finance may be risky because it may cause assets liabilities mismatches. Therefore the company must re-finance either by securing a long-term loan, issuing debentures, or by issuing new equity to its current shareholders. Growth is long-term focused so the company should have raised long-term permanent finance to fund the growth strategy.
- If the business cannot get the cash resources it requires to support the growth strategy then the business owners should consider deferring growth to a future date until the business has acquired all the cash resources required to fund the growth strategy. The business should also consider pulling out of the strategy altogether because it is better to retrench and secure the business’ future than to have growth that eventually leads to insolvency or bankruptcy.
Overtrading is common in small businesses because they grow rapidly without sufficient cash and working capital to do so. Small to medium businesses must negotiate credit terms, secure overdraft facilities, or raise long-term finance well before they commence implementing their growth strategies. Growth strategies must be underpinned by cash resources otherwise such growth may lead to a financial disaster.