What are the dangers of overtrading?
Business is a complicated old game sometimes. Just when you think you’ve got your head round one thing, you realise there’s another rule you didn’t know about!
Here’s a good example. Did you know it’s possible to get your business into serious financial trouble by selling too much?
Surely that’s not possible... after all, if you sell loads; you’ll have plenty of money coming in. But there is a condition called overtrading, where a business sells too much too quickly and grows too rapidly. Essentially the business runs out of cash.
Here’s how it can work. Let’s say your business makes widgets, which sell for £10. To make a widget you have to buy in materials for £7. That means £3 profit per widget.
You start the month with £700 in the bank. You win an order for 100 widgets which will generate you £300 profit. But you have to first spend £700 on materials from your supplier, which demands cash up front.
Your customer has purchased on 30 day terms and won’t pay their £1,000 bill till the end of the month. So you have an empty bank account for a month. And then another order comes in, for another 100 widgets.
But you don’t have any money to pay your supplier for new materials until the end of the month. You’re overtrading – selling more than you can deliver – and your business has run out of cash. It probably means you’re going to lose your new order to a competitor.
Of course there are some simple ways out of this scenario, such as an overdraft, short-term loan or credit terms with suppliers. But throw in the complications of day-to-day business life with salaries, rents and other bills to pay, and you can see how many businesses tread a very fine line between staying liquid and running out of cash.
Overtrading can affect different businesses in different ways. Even a service business selling someone’s time can find that too many hours sold become difficult to deliver profitably, especially if they have to buy in freelance help.
So it’s something that has to be anticipated and planned for. Here are five signs that your business is growing too fast and you need to think carefully ahead:
You need to borrow money to make it through each month
A classic sign of overtrading. Dipping into an overdraft occasionally is OK, and using a small business loan to get through a project is fine, but when you need to borrow cash regularly it’s a warning sign. Business life has a habit of throwing unexpected costs at you now and again, and if your business doesn’t have cash reserves to call on, it could be a problem. Remember that banks are wise to businesses running up big debts and going under, and small businesses like yours are less likely to be offered business credit. Instead you may be asked to put your own personal assets up as collateral. Do you really want to risk your home to run a business with tight profit margins?
Your profit margins are small
Some businesses operate in crowded marketplaces, and that usually has the effect of pushing prices down. Which pushes profit margins down and affects cash flow. Low profit margins make business hard work. You have to work harder to get the sale in the first place, and really have to juggle the cash to make it work.
Late payments are seriously affecting your cash flow
One of the effects of this recession is a reduction in the speed of payments from customers. And for businesses that already have a delicate cash flow it can be a kiss of death. Be clear with all customers what your payment terms are and don’t be afraid to chase money when it’s late. It’s your money that customers are unfairly holding onto; don’t play banker with an interest free loan.
A key supplier is getting nervous
Really important suppliers might know you have a problem before you do. They will have watched with delight on one hand as the amount of stuff you order goes up... and with some concern on the other as your payments slow down. If you are experiencing problems or can see issues arising down the line, talk to your suppliers quickly. It’s usually a lack of communication that makes people nervous.
Your accountant has gone a funny colour
A good accountant will spot you are overtrading before you do. And it’s their job to warn you about it and help you put a plan in place to manage it. Your accountant could be your best friend to help you survive the next few months.
