Overtrading: Definition, Causes, Consequences and Remedy
We have heard the word “Overtrading” used by bankers, credit rating organization and analysts. It’s therefore important to understand what is Overtrading, how it is cause and what serious repercussions will happen and as financial executive what we can do.
So what is Overtrading?
In simple word, it denotes a condition in which the resources in particular the liquid resources of a business are insufficient to maintain the ...view middle of the document...
For example, assuming the present turnover is $12 million and average debtors of $250,000. If turnover increase by 30% and assuming the same credit terms on the new turnover, its debtors are likely to rise by 30% i.e. $750,000. So this $750,000 needs to be obtain from existing working capital resources or injection of share capital. If management ignores this point by “overstretching”, it will face the “Overtrading situation”,
• By increased investment in fixed assets like land and building, machinery, etc and acquiring investments in a subsidiary or associated companies without a corresponding increase in equity or borrowings. Any increase in the above-mentioned capital expenditure will then deplete the net current assets,
• By allowing a longer than usual cash conversion cycle namely by the increase in stock levels and extending exceptionally long credit,
• Through trading losses which will reduce the net current assets. This also happened in cases of abnormal losses like redundancy payments, additional contribution to pension funds, payments of damages...