Overtrading

ACCA F9考試：Overtrading

To attract investors to buy preferred shares, the company needs to pay a higher return to compensate for the additional risk compared to debt.

It also can be referred to as undercapitalisation and often occurs when a business grows very rapidly without increasing its level of long-term finance.

The result can be a liquidity crisis.

This often can happen at the start of a new business, because:

there is no reputation to attract customers, so a long credit period is likely to be extended to break into the market;

if the business has found a "niche market", rapid sales expansion may occur; or

smaller companies which are growing quickly often will lack the management skills to maintain adequate control of the debt collection period and the production period.

For the above reasons, the amount of cash required will increase.

However, companies in this position often will find it hard to raise long-term finance and, hence, overtrading and business failure may result.

The indicators of overtrading include:

declining liquidity;

rapidly increasing turnover;

increasing inventory days;

increasing accounts receivable days;

increasing short-term borrowing and declining cash holdings;

large and rising overdraft;

declining profit margin; and/or an increasing ratio of sales to fixed assets.

If a business is suffering from liquidity problems because of overtrading, then the aim will be to reduce the length of the cash operating cycle. Possibilities to consider include:

reducing the inventory holding period for both finished goods and raw materials;

reducing the production period (this is not easy to do but it might be worth investigating different machinery or working methods);

reducing the credit period extended to accounts receivable and tightening up on cash collection;

increasing the period of credit taken from suppliers;

increasing the level of long-term finance (i.e. an equity or debt issue, with a new share issue being probably preferable to increasing debt in a risky company); and/or reducing the level of sales growth to a more sustainable level.