Growing too quickly can leave you over-stretched and without the resources you need to fulfil your commitments. If you know what overtrading is and how to spot it early, it's much easier to prevent it from happening.
In this article, we'll discuss what overtrading really means - and how to spot it early before it starts to harm your small business.
What is overtrading?
Overtrading occurs when a business expands too quickly without the resources to support that growth. This could be a lack of cash, staff, or production capacity and means the business cannot deliver on its commitments to employees, suppliers, and customers.
Common causes for overtrading
While overtrading can be caused by a combination of factors, some common triggers include:
- Making a big capital investment before revenue is generated.
- Late invoice payments from customers or clients. Nearly one in 10 small UK businesses say late payments threaten their survival [1].
- Accruing unexpected expenses.
- A sudden increase in demand or seasonal business trends.
- A sharp increase in stock.
- Incurring big costs on a long-term contract before the customer pays you.
- Underestimating the cost of doing business.
How to spot the signs of overtrading
Cash shortages and interruptions to cash flow can be strong indicators of early problems. In Goodacre's experience, most businesses fail because of poor cash flow management rather than a lack of profits.
"Overtrading is a sad consequence of expansion often not being managed correctly and soon the cash flow becomes a real problem,” says Andrew Goodacre, Chief Executive Officer of the British Independent Retailers Association, “as businesses expand, cash flow management is critical."
In the UK, 13% of SMEs see cash flow/ issues with late payment as one of the main obstacles to running their business [2]. The consequences of poor cash flow can include having to borrow money or using a bank overdraft, paying suppliers late, unfulfilled orders, and a lack of cash for salaries or equipment.
Data from the Bank of England revealed that the proportion of limited company SMEs with debt was around 45% by May 2021. This is more than double the proportion seen before the onset of the pandemic [3].
This can lead to damaged relationships, a tarnished reputation and a lack of sufficient cash for growth. In the worst cases, it can lead to the business failing.
How to avoid overtrading
You can avoid overtrading by regularly managing your cash flow. Consider leasing equipment instead of buying. Reduce your stock levels to decrease your required working capital. Minimise the risk of late payments from your customers, and negotiate better payment terms with your suppliers. Here is some more detail on each of these measures.
1. Manage your cash carefully
Consider using accounting software or asking your accountant to help you better manage and forecast your cash flow. Clear monthly data on your cash reserves will enable you to spot and plan around any shortfalls or seasonal trends that can otherwise lead to overtrading.
2. Lease instead of buying equipment
Leasing equipment, instead of purchasing it, can be a good way to avoid making big payments upfront. Instead, you can spread the costs over several months, leaving you with more cash to cover your other monthly payments. Leasing can also sometimes be cheaper than buying.
3. Reduce your stock levels
"Excessive stock increases the working capital your business needs," says Goodacre. "It is worth bringing in smart Electronic Point of Sale (EPOS) system to help with your stock management." An EPOS automatically tracks all your transactions in one place from goods brought in to sale out, so you can actively monitor and reduce stock levels according to demand.
4. Look at your business model
Minimise the risk of late invoice payments by re-evaluating your business model. For example, perhaps you could take more payments upfront, or you might consider moving to a subscription model to receive payments more regularly.
Automating your regular invoices will also help to ensure they're sent on time, increasing your chances of getting paid sooner rather than later.
5. Negotiate with suppliers
If your supplier payment terms aren't working for your business, consider negotiating by extending payment periods or even increasing payment frequency to help you better manage and project your cash flow.
"Ambition is good and must be encouraged," says Goodacre. Yet expansion needs to be carefully planned for and it's important to be aware of the potential for overtrading, so you can take steps to prevent it. That way, when growth opportunities come your way, you will be better equipped to take advantage of them.
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What’s more, every pound you invest in your business works harder for you by earning Membership Rewards® points that you can use on anything you like, such as office equipment².
- The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
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Sources:
[1] Federation of Small Businesses, Small Business Index
[3] Bank of England, The impact of the Covid pandemic on SME indebtedness
