Overtrading definition
/What is Overtrading?
Overtrading is the practice of conducting more business than can be supported by a firm’s working capital. When this happens, a company usually runs out of cash, placing it at considerable risk of bankruptcy. As an example of overtrading, a company seeking more sales offers easy credit to its customers on long payment terms. The outcome is that the firm has to pay for the goods it sold to the customers, but will not have any proceeds from the sales for a long time, and so does not have sufficient cash to pay its suppliers. Overtrading can be avoided by regularly updating a cash forecast, as well as by maintaining a line of credit with a lender.
A major cause of overtrading is expanding a business too fast, and especially when there is a disparity between the payment terms for suppliers and customers. For example, if a fast-growing business is paying its suppliers in 30 days but is averaging 45 days payments terms with its customers, then it will require more working capital for every incremental sale. The solutions are to alter the payment terms to bring them into alignment, or to scale back sales until internally-generated profits can cover the extra working capital requirement.
The concept also refers to excessively high levels of trading by a securities broker, usually in order to earn a larger commission. Alternatively, it can refer to excessive trading by an investor, which may run counter to his or her investment strategy.
Example of Overtrading
A small clothing company, Quixotic Clothiers, has been seeing a steady increase in demand. To capitalize on this trend, the owner decides to open five new stores in different cities, hoping to boost revenue significantly. However, the company does this without securing additional financing. This results in the following consequences:
Increased expenses. Opening new stores involves substantial costs—store leases, renovations, staffing, inventory, and marketing expenses. The company's current cash reserves are insufficient to cover all these expenses.
Cash flow problems. To stock the new stores, the company places large orders with suppliers. The suppliers require payment within 30 days, but the new stores are still not generating enough revenue to cover these expenses within that timeframe.
Credit strain. Unable to cover all costs, the company begins to rely heavily on short-term bank loans and credit lines, quickly accumulating debt.
Inventory issues. Since the new stores aren’t fully established, sales are slower than expected. This results in excess inventory, which ties up even more cash.
Supplier relations. Late payments to suppliers lead to strained relationships, which could result in delays in new shipments or even loss of credit terms. This jeopardizes the company’s ability to stock popular items, impacting sales further.
Because the company overextended without adequate funding, it quickly runs into a cash shortage. It is forced to cut costs, close some of the new stores, and negotiate extended payment terms with suppliers, all of which damage its reputation and hurt its growth potential. In this case, Quixotic Clothiers overtraded by expanding too fast without the capital to support its growth, creating unsustainable pressure on its resources and finances.