For many years, growth has been an overriding objective for the majority of UK businesses. Winning a big new contract, gaining a major new customer or successfully launching a new product or service are all events to be celebrated. Increased sales are an unchallenged positive. But if that expansion is unsustainable and worst of all, unplanned, it can be at the expense of profitability and a cause of sharply increased financial risk. Overtrading is one of the major causes of business failure. Too often, management omit to ask themselves a key question: do we have the financial and human capacity to support the higher activity levels?
What is overtrading?
Overtrading means not having sufficient resources to carry on trading without creating potentially dangerous downsides, such as a cash flow crisis, supply and production bottlenecks, staff shortages and a reduction in quality and service standards. It’s usually associated with rapid growth, but it can happen even when sales are static or falling, but past losses have eaten away at a company’s liquidity and working capital.
The problems may not necessarily be long-term. They can be seasonal, such as in retail and hospitality businesses over the festive season. It could be a temporary blip in a manufacturing or assembly process. It may be a delay in payments by a major customer, restricting cash flow. Basically, overtrading can happen at any time in any business, even previously successful and profitable ones.
What are the underlying causes?
At its core, overtrading is all about how much working capital and funding a business has. The reality is that increased sales require higher working capital and equally, reduced working capital means trading levels should be restricted.
With most business models, if orders and sales rise then inventory will go up, as will receivables from customers, stretching cash flow. The supply chain will be challenged: can suppliers cope and will they increase their credit limits to allow more materials to be purchased for increased production or finished goods sourced for onward sale? Will trade insurers raise their cover to support suppliers’ increased exposure? Can production lines cope and is warehouse and logistics capacity flexible enough to deal with higher volumes? Can the extra staff needed be recruited?
If the answer to any of these questions is ‘no’ or ‘not sure’, management need to click on ‘pause’ and remedy the potential problems before the growth overwhelms them.
Where can overtrading lead to?
The ultimate downside is overtrading leading to a formal insolvency and a business failing because of the resultant cash flow crisis, either because unpaid creditors take enforcement action or lenders call in their facilities. Jobs are lost, while suppliers and other stakeholders suffer losses. The conduct of Directors will come under scrutiny.
How can overtrading be avoided?
Overtrading shouldn’t be a problem if management stay ahead of the game, putting a range of measures in place either ahead of growth or as early as possible when it starts. The trick is not to be either complacent about the implications of rising sales, or to panic about the first signs of working capital or operational stress.
With some careful and proactive planning, there is a wide range of actions that can be taken to safeguard your business from the pitfalls of overtrading.
1. Timely management information
Constantly monitor cash flow and working capital.
2. Inventory
Closely watch stock levels. Is too much working capital tied up in stock, supplies or raw materials? Can it be reduced? Only order when necessary. This will free up cash and reduce financial pressures.
3. Activity levels
Should growth be scaled back? It can be hard to turn down sales, but it’s vital to ensure orders can be delivered on time and to the customer’s expected standard to avoid reputational damage. Focus on eliminating loss-making or marginally profitable business.
4. Review existing funding facilities
Are they adequate? Can they be increased or made more flexible?
5. Asset finance
Buying equipment or machinery for new contracts or expanded production is a costly upfront investment and a drain on cash flow. Leasing deals should be considered as an alternative.
6. Receivables funding
Financing existing and increased turnover by invoice finance and invoice discounting can be a safer way to manage cash flow and provide the liquidity to meet outgoings.
7. Supplier payment terms
Negotiating more generous payment terms with suppliers will ease cash flow pressures. Can longer payment terms be agreed in return for regular or increased orders?
8. Customer payments
Tightening cash collection is vital to avoid having scarce finance tied up in debtors. It may be worth offering discounts for early settlement of invoices.
9. Cost cutting
Can costs be reduced to save cash and increase margins and profitability?
10. Communication
Keeping stakeholders, such as customers, suppliers, credit insurers, lenders and staff up to date with growth plans and progress should be a top priority. It’s vital they hear the reality from the horse’s mouth, rather than gossip, rumour and fake news from elsewhere.
Getting expert advice
Growth and the managerial, operational and cash flow management pressures it creates can limit bandwidth for dealing with problems as they emerge. Executives can be become too preoccupied with day-to-day issues to take strategic decisions with the independence they demand. Seeking advice from experienced outside professionals should always be seen as a proactive and positive action as an extension to your in-house team. Properly briefed, their input will be a net benefit rather than an additional cost.
At Opus, we have extensive experience assisting business owners and directors with concerns and challenges, and we will always work with you to find the best solution for you and your business. If you would like to speak to us, one of our Partners would be more than happy to have a non-obligatory, confidential chat with you. We can be contacted at rescue@opusllp.com or call us on 0203 995 6380 and we will arrange for a call with one of our specialists.