'Overtrading' is an imbalance between the work a business receives and its capacity to do it. Overtrading is a symptom of fast-growing businesses, which chase sales and profitability at the expense of liquidity.
This is common in new businesses, which tend to offer long credit periods to customers in order to establish themselves in a new market. At the same time many suppliers offer only short credit periods (or insist on cash payments) as the new business has no track record. This gap between paying suppliers and receiving cash from customers is often financed via overdrafts. Eventually overtraded businesses enter a negative cycle where banks will not extend their overdraft any further. Growing interest costs and the associated debt means their financial status eventually reaches insolvency.
"Yesterday is a cancelled check. Today is cash on the line. Tomorrow is a promissory note."
On the opposite end of the spectrum of overtrading is overcapitalization. An overcapitalized business has excess assets, which are not being utilized effectively. In essence it is not maximising returns in relation to the size of its assets and in particular its cash. This is not so risky as overtrading but the money should be
- used to finance long-term projects or
- returned to shareholders.
Overcapitazation is often a symptom of a previously successful, mature businesses with minimal future growth prospects.
Finding the balance
It is difficult for a growing business to turn away sales, but success can kill a business as quickly as failure.
Controlled and managed growth is critical to the future of a business.
- Growth demands investment and only a certain level of growth can be financed by internally generated cash.
- Further growth requires external investment and there's only so much money shareholders will commit and banks will lend in the short term.