What is Overtrading?

Overtrading is when a company takes on too much work and does not have the resources or facilities necessary to complete it.

Overtrading is a danger to all growing businesses and a trap that many fall victim too. Most people will assume that all growth is good and companies should take on all the potential customers who wish to deal with them, but this is not the case.

All companies have a limit of clients that they are able to serve without there being an adverse effect on their overall operations. Should your company go passed this then it is likely that you are overtrading and at risk of experiencing dire consequences.

In this article we will look at overtrading in detail and how you can avoid it.

What is overtrading?

Overtrading occurs when a company takes on too much work, usually as part of growing too quickly, and does not have the stock, resources, staff, facilities, and/or capital needed to complete it within the agreed timeframe, to the necessary standards, or even at all.

Overtrading companies will usually try to fuel this unsustainable growth with credit and finance.

Overtrading is possible at any business but it is much more common at startups and scaleups that are still seeking to establish themselves and secure a foothold of market share. It has a close association with the retail industry but can easily occur in any sector, especially if their businesses typically have a short lead to customer time.

A simple example is:

A company sells computers to businesses. It has 10 in stock and no capital to buy more without receiving payment first.

A client wants to place on order for 30 computers with 30 day payment terms.

Rather than trading within their limits, the company takes the order and buys the remaining 20 from their supplier with finance which has 30 day terms and a late payment fee . This cost of finance means that the profit on the extra 20 TVs is reduced and will be further so if the customer is late paying and they can’t pay the finance on time.

They then get an order from a new client for 15 computers. As they are still waiting to be paid by the initial client they again take out finance to buy stock.

In isolation either of these deals would likely be fine but when it becomes the normal operating model overtrading’s effects will soon be felt.

What are the effects of overtrading?

There are many negative effects caused by overtrading. A company may experience some or all of these.

If you are worried that you or a client is engaged in overtrading, see how Red Flag Alert business reports will show you.

Inability to meet deadlines – Unsurprisingly, when companies take on more orders/clients than they can satisfy it becomes impossible to meet all of the variously agreed deadlines. If the order volume is not brought back into realistic parameters then this effect will compound over time.

This also means that any unforeseen delays, e. g. broken machinery, staff absences etc., can have devastating effects which an overtrading company may not be able to recover from.

Decrease in quality – As staff rush to manufacture goods, fulfil orders, or provide services overall quality tends to drop. Symptoms can include subpar items being released as there is no time to manufacture a replacement, orders with incorrect or missing items, and mistakes being made and not noticed as staff rush to meet deadlines.

Staff burnout and dissatisfaction – Constantly overworked staff are prone to burnout which can lead to increased staff absences, lower job satisfaction, and resignations. This further effects a company’s ability to meet deadlines and incurs costs as new staff need to be recruited and trained.

Increased cashflow interruptions – UK businesses are notoriously bad payers and it’s a rare company that does not need to expend time and resources in chasing up payment from at least some of their clients. This can present a real challenge to overtrading companies as staff do not have the capacity to chase debts which leads to increased time to revenue.

Clients may also choose to withhold payment if they feel that the did not receive the quality of goods/service they expected or experienced a delay themselves, often they will try to negotiate a discount to compensate them.

Shortage of cash and an increased reliance on overdrafts, finance, and short term credit – Overtrading companies generally have to rely on credit solutions to meet short term financial obligations and cover operating costs.

Usually this is caused by a combination of increased capital needed to fulfil the increased amount of orders and delays in payment from customers. Once a company has been caught in this cycle it can be incredibly difficult to get out of.

Increasing debts – Short term lending comes at cost and without fastidious debt management debts will inevitably pile up.

Decrease in profit margins – Whilst overtrading will initially show increases in revenue the cost of bringing it in will also increase. Whether it is caused by debt recovery or lending/invoice financing each sale the company makes will be worth less as time goes on.

Difficulty paying suppliers – In the initially stages of overtrading a company’s suppliers will be pleased at the increases in order value. But as its effects start to be felt a company may find it difficult to pay suppliers on time. This can lead to orders being limited or even refused entirely, further impacting a company’s ability to carry out the work it has committed to.

Ultimately, not paying suppliers can lead to actions such as CCJs or more serious legal actions.

Damage to the company reputation – As deadlines get missed, quality declines, and suppliers go unpaid a company will begin to gain a bad reputation. This can lead to clients going elsewhere and suppliers refusing to deal with or offer credit to an overtrading company.

Insolvency – This is the inevitable end of all companies that do not recognise that overtrading is not sustainable. What is so dangerous about overtrading is that it can occur very quickly. Once debts have started to mount all it takes is a brief interruption in cashflow or change in demand to make a company unable to meet them.

Why do companies overtrade? 

If overtrading is known to be detrimental then why do companies consistently do it?

The simple answer is due to a lack of knowledge and experience on behalf of the company directors.  

This is also the main reason that overtrading is much more common at smaller companies, as large companies will have enough senior level staff who are aware of the need to operate within their company’s capabilities.

Most people would equate increased business and revenue with increased profits and this is usually the mistake made by directors that initially tips companies into overtrading. Without proper financial advice directors will be left scratching their heads at plummeting profits despite revenue being at its highest.

So long as a company hasn’t reached the tipping point of insolvency or a terminal amount of debt, overtrading can be relatively swiftly corrected merely by reducing the amount of business taken on to manageable levels and implementing a sound plan to pay off any debts that have been accrued.

Sadly, the knee jerk reaction of most directors is to trade their way out of trouble which of course only furthers the problems caused by overtrading and makes a business’s failure more likely.

Red Flag Alert business reports contain all the information you need to perform excellent financial due diligence and identify any potential customer that is engaging in overtrading.