Overtrading
- Over-capitalization: If a company has excessive inventories, accounts receivable and cash, and very few accounts payable, there will be overinvestment in current assets. The company will be over-capitalised.
- Under-capitalization（overtrading）: when a business tries to do too much too quickly with too little long-term capital, so that it is trying to support too large a volume of trade with the capital resources at its disposal.
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Even if an overtrading business operates at a profit, it could easily run into serious trouble because it is short of cash. Such liquidity troubles stem from the fact that it does not have enough capital to provide the cash to pay its debts as they fall due.
Symptoms of overtrading:
①Rapid increase in sales revenue compared to long-term finance.
②There is a rapid increase in the volume of current assets and possibly also non-current assets.
a）Rapid increase in receivables and inventory as sales and production increase.
b）Increase in inventory days and receivable days indicate that increase in inventory and receivable is higher than increase in sales.
c）Build up inventory level for planned higher sales
d）Offer more generous credit terms to customer to encourage sales
③Most of increase in assets are financed by credit, only a small increase in equity capital:
a）Trade accounts payable – the payment period to accounts payable is likely to lengthen
b）A bank overdraft, which often reaches or even exceeds the limit of the facilities agreed by the bank
④Some debt ratios and liquidity ratios alter dramatically:
a）The proportion of total assets financed by equity capital falls, the proportion financed by credit arises
b）Current ratio and quick ratio decline
c）The business may have a liquid deficit, i.e. excess of current liabilities over current assets.
⑤Attempts are then made to induce receivables to pay earlier. This is usually done by offering cash discounts. Alternatively the services of a factor may be used.
⑥Falling profit margins
a）Gross profit margin is lower because some prices have been reduced to obtain extra sales.
b）Net profit margin is lower because overhead costs are higher, these including wages to extra sales staff, rent extra warehouse and write-off out-of-date inventory
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Possible solutions to reduce the degree of overtrading
1）New capital from the shareholders could be injected.
2）Better control could be applied to inventories and accounts receivable.
The company could abandon ambitious plans for increased sales and more non-current asset purchases until the business has had time to consolidate its position, and build up its capital base with retained profits.
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