What is overtrading:
Overtrading is not something to take lightly as it can lead to business failure. Overtrading is when you conduct more business than can be supported by your business’ working capital. This often leads to cash flow problems, which may put the business at a high risk of insolvency.
Overtrading happens when there is a time gap between paying suppliers and being paid by customers. This could be caused by, for example, a company wanting to raise sales and offering easy credits to its customers and on long term repayment terms (without proper credit vetting). The problem with this is that the business has to pay for the good it has sold, because they also bought these from their suppliers or must pay for resources used to make these products, but will have receipts from its customers for some time.
Another example is what happens to some construction companies where a company could receive several large contracts. They will then need to spend money to cover all the expenses of the particular projects but are only paid a few months later, especially where the government is concerned.
Overtrading can also be caused by the seasonal nature of a business, where the business tends to consume resources in a certain period during the year when demand is low. Then suddenly demand booms again and there is no working capital to meet this demand.
What are the symptoms of overtrading:
- Lack of cash
- Loss of supplier support and may end up losing key suppliers because of failure to pay them on time
- Very low inventory turnover ratio.
- Significant increases in short-term borrowing, which in turn overexposes the business and raises the cost of capital to the business. At some point, the business will find it difficult to borrow from lenders and some lenders may end up asking for personal guarantees
- Rapid revenue growth
- High revenue growth but low gross and operating profit margins.
- Significant increases in the payables days and receivables days ratios (Struggling to collect from customers and struggling to pay suppliers)
- Your business struggling to pay its suppliers
- Significant increase in the current ratio.
- Low levels of capacity utilisation.
- Persistent use of a bank overdraft facility.
How to prevent overtrading:
- Do a proper cash flow forecast that will serve as an indication of red flags well in advance so that you can take necessary and corrective action before it is too late
- Identify where your business is losing money and start cutting costs
- Often businesses push for revenue and forget about everything else. Businesses must balance the push for revenue with the push for cash and profit stability. it is better to have cash and good profit margins than to have huge sales volume but that is not supported by cash and good profit margins
- Do not do repeat business with people/businesses you always struggle to get payments from. This should be documented in your credit policy.
- Design and adhere to effective credit control and policy
- Reward customers who pay on time with early settlement discounts
- Negotiate with customers to pay you on time
- Negotiate for longer payment terms with your suppliers
- Where you are working on huge projects, ask for deposits that cover part or of your working capital needs
- For some businesses, it makes sense to produce stock as and when orders have been confirmed and deposits for these orders have been received. This can also be good practice
- Only produce stock sufficient to meet current demand
- Match sales with production cycles and by holding stock for less time
- Ensure that working capital is not needlessly tied up in stock. This can provide the business with much-needed cash to run a business smoothly.
- Develop a habit of saving for the business, aim to save at least 20% of your profits months in order to provide cash for future projects and working capital needs.
- Once invoices are paid, set aside the 15% that belongs to SARS so that you are not running around borrowing money to cover your VAT liabilities.
Overtrading and reckless trading & solvency and liquidity in terms of the Companies Act.
The Companies Act, in terms of Section 22, states that a company must not carry on its business recklessly, with gross negligence, with intent to defraud or trade under insolvent circumstances. If a company trades under these circumstances the commissioner may require the business to cease trading. In terms of Section 4, companies must also meet the ‘solvency and liquidity test.’
According to the Act, a company satisfies the solvency and liquidity test at a particular time if, considering all reasonably foreseeable financial circumstances of the company at that time-
a) the assets of the company, as fairly valued, equal or exceed the liabilities of the company fairly valued
b) it appears that the company will be able to pay its debts as they become due in the ordinary course of business for a period of-
(i) 12 months after the date of this test or
(ii) in the case of a distribution contemplated in paragraph (a) of the definition of “distribution” in section 1, 12 months following that distribution.
It is important for businesses to keep an eye on overtrading and to avoid it at all costs as it may lead to insolvency and the business going under. If the business is trading under insolvency, this may amount to reckless trading and this is in contravention of Sections 22 and 24 of the Companies Act.
Preparing regular cash flow forecasts can be key to identifying when a cash shortfall is likely, and this, in turn, allows directors the opportunity to take corrective measure before the crisis hit the business. Also key is ensuring that the business has a watertight credit control policy and is not giving out credit recklessly.