What are the dangers of overtrading?

Overtrading occurs when a business lacks adequate resources to satisfactorily complete a client's order.

This issue is particularly prevalent among young, rapidly expanding small enterprises.

While an increase in demand for your offerings may initially appear beneficial, consistent overtrading can induce lasting damage to a company.

This includes complications such as cash flow disruptions, potential legal disputes, and in extreme cases, even insolvency.

What is overtrading?

Overtrading is a situation that arises when your business gets a new order, but you're unable to fulfil it due to insufficient working capital, inventory, materials, or workforce.

Indicators of overtrading include:

• dependence on an overdraft on a monthly basis
• narrow profit margins
• habitual late invoice payments by clients.

The consequences of overtrading can be detrimental and may include:

• a cash flow disparity, resulting in an inability to meet financial obligations such as bills and employee wages
• delivery of subpar products or services, leading to customer complaints and potential damage to your business reputation
• legal action from suppliers or customers due to unpaid supplies or unfulfilled orders.

In the most severe scenario, your business may face insolvency and be compelled to cease operations.

An example of overtrading

A company embarks on a series of new ventures; however, it depletes its financial resources, leaving it unable to pay its suppliers.

Consequently, the suppliers halt their deliveries, stopping the business from fulfilling its orders.

This scenario results in a ripple effect where the company doesn't receive payment from its customers and suffers damage to its reputation.

As time progresses, the financial strain on the business intensifies due to mounting debts and lack of incoming revenue.

Overtrading can manifest in other ways as well, for example:

• a lack of adequate storage for client-ordered inventory
• extended intervals between receivables that disrupt the balance with expenditures
• insufficient workforce to meet increasing demand, thereby slowing down service delivery.

How to reduce overtrading

There are a number of actions you can take to reduce the risk of overtrading.

Monitoring inventory levels

Keeping a close eye on your inventory levels can help optimise your working capital and improve cash flow.

Consider implementing strategies to reduce stock, such as ordering materials and supplies only when necessary to avoid overstocking.

Purchase order finance

Purchase order financing can be beneficial if you're unable to pay a supplier to fulfil an order.

In this arrangement, a lender provides a loan to cover the cost of supplies.

Once the customer pays, the lender deducts their fees and gives the remaining amount to your business.

Learn more in our guide to purchase order financing.

Lease/hire purchase

Hire purchase or leasing can alleviate the financial burden of acquiring costly equipment, machinery, or vehicles needed to fulfil orders.

Leasing involves making rental payments over a set period in exchange for the asset, while hire purchase allows you to gradually buy an asset from the lender.

Read more about leasing and hire purchase.

Invoice financing

Invoice financing is another method to improve your cash flow.

If a client's payment is pending, you can use the unpaid invoice as collateral to secure funding, gaining access to up to 90% of the invoice's value.

Learn more about invoice finance.

Managing late payments

Managing late payments from B2B clients is also crucial; delayed payments can disrupt your cash flow and hinder order fulfilment.

Strategies to address late payment include conducting credit checks on new customers, ensuring accuracy of invoices, using accounting software for automated follow-ups, and building relationships with payment officers.

The Small Business Commissioner can assist if a larger business (>50 employees) presents payment difficulties.

Learn more about how to deal with late payments.

Reducing cost to benefit cash flow

Cost reduction can also help enhance your cash flow.

Consider collaborating with other businesses to share resources, reviewing and cancelling unnecessary subscriptions, employing part-time or freelance staff, downsizing office space, taking advantage of tax reliefs, and reducing travel costs through advanced booking or virtual meetings.

Learn about other ways to help reduce business costs.

Supplier negotiation

Negotiating with suppliers could free up some cash, e.g., by extending payment terms in exchange for more orders.

It's essential to maintain good relationships with reliable suppliers, as supplier-related issues can disrupt your business operations and harm your reputation.

If necessary, don't hesitate to change suppliers.

See our guide on reviewing your supplier chain for further guidance.

Supporting cash flow

Lastly, regular monitoring of your cash flow is crucial.

Creating regular cash flow forecasts will help you identify any potential shortfalls and secure finance to address them.

Check out our guide on how to protect your cash flow from seasonality.

How to recover if your business is overtrading

If overtrading is posing a significant challenge to your business, it might be wise to temper the pace of your business growth to effectively manage customer demand.

Here are some strategies to consider:

Reevaluate your growth strategy

Overtrading signals a need to reassess your business strategy, examining the objectives, targets, and goals you've set.

It's possible that your ambitions may have outpaced your resources, or you may not have adequately prepared for increasing demand.

Reflecting on your current situation can provide insights into necessary corrective actions.

Read out guide on reviewing your business plan.

Implement a sales hiatus

Temporarily halting sales can provide a breather, allowing you to focus on fulfilling existing orders.

During this period, you could invite potential customers to join your email mailing list, ensuring they'll be notified when your product or service becomes available again.

Assess your product/service portfolio

Overtrading may result from an overly diverse product or service offering.

Conduct a thorough review of your portfolio and consider eliminating certain items if needed.

This process can help streamline your operations, enabling you to concentrate on your core offerings.

Adjust your pricing

An increase in the price of your product or service can dampen customer demand, making it more manageable.

While this strategy may reduce the volume of customers, it can also allow you to better cater to those willing to pay a premium for your products or services.

It's important, however, to carefully consider this option, as drastic changes in pricing can potentially alienate existing customers.