CO - Finnovation

Business failure by overtrading

Business failure by overtrading

Remarkable sales figures and improved short-term profits do not necessarily indicate ongoing success of a business.

Strange as it might seem, fast growth is not always sustainable and may damage the cash flow and the profitability of a business in the longer term, especially if the business is in its developing stage, or if the business does not have the adequate resources to satisfy the increase in demand.

Unfortunately, sudden increase in growth motivates business owners to meet such growth and encourages them to invest further in new assets and other resources depending on the nature of their business - such as bigger premises, more machinery and IT equipment, stock and vehicles while taking on more people. Very often, however, business owners will have to borrow more money to finance the newly employed assets and to compensate for the increased costs required to meet such increase in growth.

This new investment may then result in business insolvency, since the increase in sales is beyond the capability of financing such investment with the normal working capital generated by the business itself.

This leads to the definition of overtrading, which every business owner should be aware of and keep in mind to prevent potential business failure achieved by overtrading:

Selling more than a business is capable of dealing with 
in terms of finance and other required resources.

 

Overtrading, which admittedly is often the result of lack of management competence and lack of adequate capital to run the business, presents a potential problem to the creditors of the business.

Creditors should therefore identify the real reason behind every request for credit, especially when such requests come from the existing debtors demanding extension of credit, or if new market entrants apply for a relatively large amount of money. This may be a clear, and early indication of overtrading!

One method which indicates whether the business of a credit applicant is adequately proportionate to the sales volume is the Net Sales to Tangible Net Worth Ratio. Tangible Net Worth refers to the owners' equity less any intangible assets. This ratio may potentially indicate any credit or management problems relating to overtrading.

However, there are several other issues by which the creditor may identify overtrading:

Significant drop in the profit margins - It may happen that the increased costs, incurred to meet the demand increase of the business over the last months, effect negatively the bottom line of the business.

Sharp rise in the variable costs - Variable costs vary directly in proportion to the level of sales turnover. Depending on the type of business, some examples of such costs would be cost of goods sold, sales commissions, shipping charges, delivery charges, costs of direct materials or supplies, and sales or production bonuses. In order to meet new orders, the business owner may opt for more expensive goods and services, which would result in an increase in turnover to meet the demand at the expense of profitability.

Higher fixed costs - When the business struggles to meet the fixed costs, it may well be another sign of overtrading. Fixed costs are those costs which remain the same regardless the level of sales. Typical examples would be rent, interest on debt, insurance, plant and machinery expenses, and salaries.

Considerable increase in the customer base - Increasing the customers in a short period of time without enhancing the capabilities of the business is the ideal recipe for business failure due to overtrading. Although businesses should grow, they should be managed to grow steadily and progressively in proportion to the increase in their resources.

Increase in the workforce to meet new orders - Increase in demand may only be temporary. Employing people to meet an unexpected increase in demand may lead to internal disturbances in terms of financial and human resources. The business owners should analyse and review the market environment and establish the reasons of any increase in demand. New employment should be sustainable in the long-term, hence it is wiser to refuse orders in the short-term than to employ more staff to meet new orders without any serious evaluation.

Recent investment - The same concept of increasing the workforce to meet new orders applies. Investment in new premises or in any other asset should only be done after a feasibility study is conducted.

If the new investment is to be financed from an external source, it must be ensured that the cash inflows generated by the investment will be greater than the cost of capital required for the investment.

Banker refuses to extend the overdraft facility - Creditors should ensure that there was no refusal of a banking facility. The banker of the business is in a much better position in the market to monitor closely the business' finances. So, if the banker refuses to grant a loan or extend an overdraft facility, the trade creditor should recognise that a higher element of risk exists in the business, and a probable reason for such a banker's refusal may be due to overtrading.

The business taking longer to pay than it used to - Another very common indication is when a business takes longer to pay due to recent cashflow problems. Cash inflows will be absorbed by the increased costs and the business will fail to honour payments due to its suppliers on time.

The creditors should therefore learn how to recognise and identify the symptoms of overtrading to prevent overdue debtors accounts if not also bankrupt debtors.

The faster a business grows, especially when growth is financed by external sources, the more likely it is that the business will be destabilised. Businesses should monitor the cost of sales and aim for steady growth on an ongoing process.

  • Josef Busuttil
    Josef Busuttil
    MBA (Henley), DipM MCIM, FCICM

    Josef is the Director General of the Malta Association of Credit Management and Vice President of the Federation of European Credit Management Associations. He is also a Credit Management Lecturer and Coach. He obtained his MBA from Henley Management College, Member of the Chartered Institute of Marketing (UK) and Fellow of the Chartered Institute of Credit Management (UK). He has contributed with intuitive workshops and presentations addressed to various business people worldwide. Josef is a regular contributor of business articles to business press.

You May Also Like

Challenging The FinTech Funding Gap In Asean To keep The Growth Engine Running
Challenging The FinTech Funding Gap In Asean To keep The Growth Engine Running

What is the preferred method for FinTechs to raise money? How much capital do FinTechs hope to rais...

Building a personal set of values - the 6 I's
Building a personal set of values - the 6 I's

Becoming a successful CFO requires persistence, hard work, technical skills, and people and manageme...

Fixed Cost Management
Fixed Cost Management

From the financial perspective, there are two types of cost that management has to deal with –...

The Future of Forex: How to Navigate the Asian Landscape for Maximum Profit
The Future of Forex: How to Navigate the Asian Landscape for Maximum Profit

To get a grasp of the evolving nature of Forex in Asia, it is pertinent that we look through the his...

Entrepreneurship: The Struggles No One Talks About
Entrepreneurship: The Struggles No One Talks About

Success is all about the money, fame, and glory. That’s the constant message we see on social ...

Boardroom commitment to security
Boardroom commitment to security

The subject of ‘Board commitment to security’ is a sensitive and often emotive one. The ...

Blockchain for Claim Management in Insurance Industry
Blockchain for Claim Management in Insurance Industry

Insurance industry has a vast potential for blockchain-driven innovations solving multiple pain poin...

Fraud Detection : Challenges in Real Time Payments
Fraud Detection : Challenges in Real Time Payments

“The financial industry is shifting towards real-time data analysis, deploying technologies su...

Bench to Market
Bench to Market

BENCH TO MARKET Some thoughts from an (interested) observer: #1    having the innovator/...

Risk Management Concepts
Risk Management Concepts

Risk Management Concepts - a practical approach. History, the Persians and risk management, an ex...

Start Up
Start Up

Millennials are now the largest segment of the U.S. labor market according to >Pew Research, an...

Granting Credit & KYC
Granting Credit & KYC

Money cost money. Credit is money. Hence, credit cost money!   Credit also carries an element o...

Money in the bank was never more important than it is today
Money in the bank was never more important than it is today

With the current spread of COVID-19 pandemic, the world has got locked down. It is an unfolding even...

Risk Based Capital- Issues, Challanges and Opportunities
Risk Based Capital- Issues, Challanges and Opportunities

Introduction A Stable insurance sector is encouraging various insurance regulators around the world...

COVID-19: the changing fortunes of industries and how businesses can thrive
COVID-19: the changing fortunes of industries and how businesses can thrive

With no end to the COVID-19 pandemic in sight, how can businesses build resilience and pivot for fut...

The death of Entrepreneur & Entrepreneurship
The death of Entrepreneur & Entrepreneurship

What amazed me was that why a person with a Net worth of 25,000 crores (nearly US 3.6 billion) could...

Stay Connected With Us