Overtrading is when a company is growing its sales faster than it can finance them, in other words, spending money it hasn’t got by taking on additional orders when it can’t afford to service or fulfil them.
This relates to a lack of working capital to fund the business and the cash cycle of contracts where creditors are often paid before payments are received from customers.
In this way a company can be profitable and yet run out of cash.
While it is healthy for businesses to pursue growth, a lack of honesty with themselves and their situation and a lack of forward planning can put them in this position. The rate of growth needs to be realistic for several reasons, including resources and capacity, both of which normally require funding ahead of income.
While there may be a strong temptation to say “yes” to new orders, a business needs to be sure those orders can be fulfilled, not only to avoid damaging its reputation but also because ultimately it can lead to insolvency.
How can a business avoid overtrading?
When there are more orders coming in than there is capacity to cope with, one solution is to price work in a way that manages demand. This need not be simply by putting up prices but more by having a pricing strategy. It may be necessary to protect the relationship with long term customers by pricing loyalty and long term commitments. Alternatively, future orders or flexible delivery might be priced at a lower rate than late orders and short notice delivery rather like the airlines. It may be that there is scope for staff to work overtime and share the benefit of increased prices.
Another way of looking at demand is to sell capacity rather than goods and services. A well-organised business ought to schedule work and know when an order can be easily fulfilled albeit on its own terms. By managing customer expectations, such as for a longer delivery timetable, a business can establish a pipeline of future work to keep everyone busy, at a level that works for the resources and capacity.
Ideally, when a business is planning for growth, it should look carefully at its finances before it starts any marketing or sales activity with this goal in mind.
For SMEs, this could include looking at the possibility of accessing regional growth funds and other cash flow and asset finance options, providing they can meet the conditions. If more funds are available then a higher level of growth can be achieved.
Negotiating arrangements with suppliers may be another possibility, especially if the business has a long-standing and good relationship with them. They might value longer term commitments and provide extended credit terms.
Another solution is to manage trading terms with customers, for example by requiring the payment of a deposit up front, stage payments, payment on delivery or reduced payment terms.
Using factoring and invoice discounting as a means of freeing up finance to pay fund orders may also be a solution as this will provide access to cash before an invoice is paid.
Having a product or service for which it is clear there is a substantial demand is not enough. To grow a business, resources and working capital are needed if it is to avoid the consequence of overtrading: insolvency due to running out of cash.