The problems of overtrading usually occur with young companies which have been experiencing fast growth in terms of sales during recent periods (cited in Brigham & Ehrhardt, 2007). Overtrading occurs because the companies which are in the initial stages of their operations have not built a solid reputation in the market yet. As a result they have to offer generous credit terms to their customers as promotional tools. However these credit terms can create imbalances between sales and production cycles by delaying cash generation (cited in Downes & Goodman, 1998). In the event that sales are growing faster than the rate at which accounts receivables are turned into cash, businesses will not have enough working capital with which to finance credit terms from suppliers. As a result, production activities will be delayed because of shortage of inventory. Therefore, when sales are growing faster than working capital, the situation is not sustainable since the company suffering from shortage of working capital will be able to meet the demands of growing sales only up to a certain point. After that it will have to stop its operations because the cash flow will not be sufficient to finance the cost of production (cited in Atkinson, 2006).
Young companies in particular have to maintain good relations with suppliers and customers in order to have access to favorable terms. As a result, these companies risk possibilities of overtrading by offering long credit terms to customers and by imposing suppliers with short credit terms on themselves (cited in Ross, 2006). The result of this arrangement is that companies have to make frequent payments to suppliers in order to maintain sufficient inventory for growing sales. However, since customers are taking longer to pay in cash, the company will not have the working capital with which to make those payments to suppliers. In this situation, the management of the company will have to apply to the banks in order to make up for the shortfall in working capital. However banks will also impose limits on the level of cash that it will lend to client organizations. In other words, overdraft from banks will be limited to a certain level (cited in Higgins, 2007). After that level, any further requests for cash will be denied. As a result, the companies experiencing fast growth in sales will no longer be in a position to pay the bills. This is one of the primary reasons leading to problems of overtrading. It can be seen from the example above that poor financial controls are the primary reasons for which businesses run out of cash and impair their abilities to continue their operations. Therefore, occurrences of overtrading can be fatal inasmuch as they endanger the continuing operations of the company (cited in Kotler & Armstrong, 2005).
As mentioned before, poor financial controls contribute to the problems of overtrading. As a result, if businesses impose tight budgetary controls, then the probabilities of overtrading are reduced. In this respect, forecasting of cash flows can be an effective tool in assessing the level of cash that will be available to the company in future periods. There are some ratios, such as the current ratio and the quick ratio, which enable companies to make an assessment of the level of cash that is available to finance the current liabilities (cited in Shapiro, 2007). These ratios will indicate the point at which the cash level is so low that the company is no longer in a position to pay off its current liabilities. Then the company is suffering from overtrading. Therefore, monitoring these ratios is one of the means of avoiding overtrading.
Monitoring ratios can alert the management of the company when it is vulnerable to overtrading. However, such monitoring is not a preventative measure because once the cash level has fallen below the acceptable limit the company will no longer be in a position to change policies quickly enough to retrieve the situation. Therefore, the management of the company must formulate policies and put those into action in advance in order to avoid overtrading. In this respect the two most important stakeholders groups that the management has to address in its policies consist of debtors and creditors (cited in Siciliano, 2007). In the event that the company has been operating in the market for some time and has built up a reputation, the management will be in a position to negotiate payments terms with buyers for shorter cash conversion cycles. Otherwise the company can offer discounts to customers who pay in cash or who purchase in shorter credit terms (cited in Ross, 2006). Managing creditors is also an important issue in the form managing longer credit terms with suppliers. In other words, one of the most important strategies when it comes to avoiding overtrading is to minimize the debtor day’s ratio and to maximize the creditor day’s ratio (cited in Evans, 2004). As a result, the company will receive cash sooner and pay out later. Another strategy for reducing this risk is to forecast sales more accurately in order to manage stock more efficiently so that cash is not tied up in inventory. Budgetary controls in capital expenditures are also critical. In this respect, the company can go for leasing rather than buying the plant and equipment in order to minimize cash outflow. These are some of the ways in which growing businesses can reduce risk of overtrading.
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