Who would have thought there’s such a thing as growing too much when it comes to your business? Overtrading is an example of the ways in which a company might find that its success has run away with it – even to its detriment. Learn everything you need to know about overtrading in accounting, from the causes of overtrading to the effects of overtrading, right here.
Who is at risk of overtrading?
Overtrading can occur in any kind of business, but it’s most often associated with retailers. It’s also much more common in start-ups and small businesses than it is in big, established chains. This is often because larger businesses are more likely to have a cushion in the event of big expenses, while longer-standing establishments are likely to have a better forecast of upcoming income and expenses.
Overtrading in accounting
In accounting terms, overtrading essentially refers to when more money leaves the business than comes into it – or, more specifically, money leaves the business before it comes in.
Often, you’ll find that your books are balanced in relation to the money owed, but you may be paying your suppliers before collecting your money from your customers. Similarly, some businesses struggle to cover wages when they’re owed earlier than incoming payments.
In other instances, overtrading occurs when you’re required to pay cash advances, make sales on credit or to hold stock for extended periods of time. Again, you may know that the money is or will eventually be owed to you, but it can make it difficult to organise your finances in the meantime.
This makes it particularly important to keep a record of your finances in relation to both money owed and actual income and expenditure. You should be comparing these figures regularly, so you know whether you’ll have cash flowing in or out of the business before you’re ready.
Causes of overtrading
As mentioned, overtrading can come about in a variety of different ways. Sometimes, it’s caused by the disparity between payment periods. For example, you may have Direct Debits coming into your business on a monthly basis, but you may be required to pay out wages on a weekly basis. In this case, it can be easy to find your books unbalanced.
This issue becomes overtrading when you accept work that you won’t then be able to fulfil. This could be because you can’t cover the labour costs or material costs of delivering an order until you receive the necessary payment. In some cases, businesses will simply ask for payment upfront to cover the costs, but this is not always a feasible option – especially if you’re operating as a new business that has yet to establish itself.
Effects of overtrading
Overtrading can have a number of effects in relation to both your finances and your business’s wellbeing. One of the key effects of overtrading is that it can lead to immense stress if you’re trying to fulfil orders without the necessary resources. This stress can often be passed along to your workforce, creating a difficult working environment.
There’s also the risk that the impact will eventually reach your customers. If you take on business that you’re unable to fulfil either at all or to the appropriate standard, you risk losing customers. In more extreme cases, you may even face action for a breach of contract or non-fulfilment. This can damage your reputation within the industry and make it difficult for your business to recover from losses.
Overtrading ratio analysis
An overtrading ratio analysis is a way of staying on top of your finances and preventing overtrading – or undertrading – before it occurs. It’s easy to conduct an overtrading ratio analysis: simply divide your net sales by your tangible net worth.
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