Overtrading: Finance and Capital

Topics: Finance, Financial ratios, Corporate finance Pages: 3 (737 words) Published: August 13, 2013
Overtrading means a situation of operating a business with insufficient long term capital to support the current volume of business. A situation in which a company is growing its sales faster than it can finance them. Overtrading often occurs when companies expand their own operations too quickly aggressively. Overtrading can arise even if the organization is trading profitably. Over-expansion of business is one of the main reasons for overtrading and therefore overtrading is also called under-capitalization. In other words, Overtrading means transacting more business than the firm’s working capital can normally sustain, placing serious strain on cash flow and risking collapse or insolvency.

Although one cannot say for sure whether a company is overtrading or not, just by looking at its financial statements, and or performing simple ratio analysis of the organisations financial statements, the financial statement is still one of the most useful external source of information that may be available to an external stakeholder in making a decision as to whether a company may be overtrading or not.

The two main causes of overtrading are:
1. Insufficient funds increasing credit sales volume.
2. Poor management practices/inefficient management.

The other symptoms are:
* Extended credit sales period taken by customers, than industry average. * Increasing sales without corresponding increase in profit. * Increasing inventory days, excessive investment in inventory, probably with no immediate need. * Increasing and excessive reliance on trade payables as a source of funds for working capital needs. * Extended trade payables periods, sometime the company takes involuntary trade payables period. * Lack of cash in hand or at bank, hence excessive reliance on bank overdraft as a major source of finance for working capital activities. * Increasing working capital cycle.

* Increasing...
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