The risks of overtrading and how to avoid them

Overtrading occurs when a company expands its sales volume but does not have adequate resources or infrastructure to support such growth, posing risks to the business.

Growth should be strategically planned and funded, with effective cashflow forecasting and monitoring of operations to enable greater success. 

What are the risks of overtrading?

Increased sales demands more from a company’s operation, putting a strain on staff, production capacity and supply chains. Without the resources to scale up properly there can be delays in meeting the sales demand, leading to reputational damage.

Matters can quickly worsen if management are not vigilant in ensuring speedy billing and effective debt collection. Without these timely cash inflows there will be pressure to find the funds to pay expenses. Payments tend to be prioritised with staff salaries to keep production going. Next, suppliers are paid in order to be able to maintain output. Often HMRC is last to be paid (PAYE and VAT) but ironically, it is HMRC that is most likely to petition for the winding up of a company.

In summary it is a lack of control of all aspects of a business that leads to a high proportion of insolvencies in companies, particularly those that have been trading for less than 10 years.

How to manage the risks of overtrading?

• Plan growth strategically

It is prudent to expand a business gradually to ensure that there are sufficient resources to support the growth. Directors must also be looking at profit margins. Problems can arise when too much emphasis is put on increasing sales, sometimes with insufficient profit margins. It is not just young companies that are guilty of this. Carillion, one of the largest insolvencies of the last decade, ran into trouble by overreaching itself by taking on too many risky contracts that proved to be unprofitable.

• Monitor cash flow

It is vital to track your cash flow to ensure that you have the funds to cover your expenses. Effective cash flow forecasting will help to anticipate additional cash flow needs in the future and provide management information to address working capital problems in a timely manner.

• Effective control of operations

This includes close monitoring of expenses to see if there are costs that can be cut without compromising on performance. Think about negotiating better terms with suppliers over a period of time. At the same time do what you can to speed up receivables, perhaps by offering early payment discounts.

Think about stock management. The use of technology can help optimise stock levels and avoid excess working capital being tied up in stock that is not required and could become obsolete.

• Strategic use of financing

Firstly, consider whether your company is getting the best deal with its bank. This would cover interest rates on overdrafts, the level of overdraft offered, whether personal guarantees are required and much more. All assets must work as hard as possible for the business. For example, invoice financing may be considered in periods of growth to speed up cash inflows. The same principle can be applied if the company has a property. Cash flow can be much improved by entering into a lease/purchase arrangement.

A review of your company’s banking and funding arrangements and accounting systems can ensure that you are in the best place to grow your company without the risk of overtrading.

Successful expansion

By considering the steps above you will reduce the risk of overtrading and instead put your business in a better position to successfully expand.