SMEs should avoid risks of overtrading

Overworked and exhausted office worker drinks too much coffee.

Successfully running a start-up SME business is often a very difficult and tricky affair. Emerging entrepreneurs face many challenges, which range from the first stages of coming up with a profitable business model and bankable business plan; putting the resources together to get the business going; and ultimately trying to turn it into a success.

By Clive Mphambela

However, when one is lucky to get into a potentially lucrative business, managing the growth of that business becomes a minefield. A few businesses hit the jackpot and grow very fast and the excitement of good business prospects results in entrepreneurs sometimes allowing their businesses to grow faster than they can sustain, a phenomenon that can be fatal to any start-up business. This phenomenon is called overtrading.

What is overtrading and why is it dangerous to business?

Overtrading often occurs when a business expands its operations too quickly or too aggressively. Overtrading eventually kills a business because the business often quickly enters a negative working capital cycle, where, if the business also happens to be financed from borrowed funds, a rapid increase in interest expenses will negatively impact the net profitability and cash-flows, leading to the erosion of working capital. That cycle feeds on itself and leads the business into further increased borrowings, which in turn lead to further increases in interest expenses and the cycle continues. Overtraded companies eventually face serious liquidity problems due to them running out of working capital.

Why does overtrading occur?

Overtrading happens when a business accepts orders and tries to complete those orders, but finds that fulfilment of the order requires greater resources than initially anticipated, that is, more people (labour), more time, more working capital or net assets — than are available to the business. This is often caused by unforeseen circumstances or events for example, such as when raw material delivery take longer than anticipated, resulting in manufacturing of an order not being completed on time, delaying delivery to the customer or and eventually getting downstream delays in getting customer to pay. The net result is that the business cashflow becomes severely impaired.

Overworked and exhausted office worker drinks too much coffee.

Overtrading is a common problem, and it often happens to recent start-ups and rapidly expanding businesses. Cash often has to be paid out of the business before cash from sales is realised. For example, wages and salaries are usually payable weekly or monthly and there may be other expenses that need to be met promptly, such as transport, telephone expenses and rent.

Although you may be lucky to pay your input suppliers on credit, and some of your customers may also pay you on credit, it usually does not take much to upset the balance.

It is also possible to run out of cash, even if your customers pay cash and do not have credit accounts. For example, you may have to pay suppliers quickly, perhaps even in advance, or you may have to hold stock for a long time. What matters is the amount of working capital and the timing of cash coming in and going out.

How can you avoid the problems of overtrading?

Prevention is better than cure. The first and most important step in dealing with a potential overtrading problem is to make an accurate assessment of your business’s cash needs: assets and liabilities.

It is often helpful to compare the assets and liabilities of your business, as it can be useful for forecasting what your assets and liabilities will be in the future. This can be done by using either cashflow forecasting and or ratio analysis. However, for either to be effective you need up-to-date and reliable financial records and for this, accurate record-keeping is crucial.

Cashflow forecasting

Since cash is essential to a business, a cashflow forecast is one of the most important management tools you can use. If you are expecting a rapid increase in business, an accurate cashflow forecast is vital. This helps you predict the money coming into and going out of the business on a periodic basis and, to be effective, it therefore needs to be broken down into relevant periods — monthly, weekly, or even daily as necessary.

Such a system will tell you whether the extra demand for your products can be effectively financed from internally generated cash, or whether you need extra short-term financial support, or whether there is a real risk of overtrading. (See our next article on the basics of cashflow management.)
Some useful ratios to watch

There are various ratios that need to be monitored in order to avoid overtrading. Along with cashflow forecasting, these ratios will help you understand your own business’ cash needs. Forecasting future ratios is an invaluable way of predicting the effect of a rapid increase in workflow.

Working capital and quick ratio — Working capital is the difference between your business’s current assets and current liabilities. Clearly, the safest position to be in is to have more current assets than liabilities, and the bigger the difference the better.

The Quick Ratio — is a similar but more demanding way of measuring cash needs. Stock is completely left out of the current assets calculation because it might take some time to turn stock holdings into cash. Only cash investments, money in the bank, cash and money owed by customers for services or products delivered are considered. A good score in the quick ratio test is usually an indication of a healthy business.

Gearing Ratio — This is the percentage of money borrowed from the bank compared with money provided by the business owners and other investors.
For example, suppose that the bank lends the business $8 000 and the shareholders have provided $12 000. The gearing ratio will be 40%, because the bank loan represents 40% of the total funds available to the business.

Gearing can help a business by boosting cash available, but it does involve borrowing potentially large sums of money, usually at a cost. There is no standard set figure or safe level for gearing, because businesses differ in many respects. However, it is generally known that the higher the gearing level, the higher the financial risk that business faces.

Because of such risks, banks are often wary of lending too much and might refuse to accept a gearing of more than 50% for example.

l Clive Mphambela is a banker. He writes in his capacity as advocacy officer for the Bankers’ Association of Zimbabwe (BAZ). BAZ expressly invites stakeholders and SMEs to give their valuable comments and feedback related to this article to him on or on numbers 04-744686, 0772206913


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