Symptoms and Signs of Overtrading | How to Know When a Business is Overtrading

In this article on the symptoms and signs of overtrading, I will be talking about how to know when a business is overtrading especially in this technologically dependent world that we now live in. I would like to begin by firstly explaining what overtrading means in the next paragraph.

What is Overtrading?

Over trading is when a business entity is taking too many expansive steps that is disproportionate to her capability. Overtrading is a term used to describe a situation when a company expands too quickly to the extent that its scarce resources are stretched out to its maximum limit.

We find loads of companies that overtrade in the fintech startups ecosystem and that has been a major reason why fintech startups fail.

There is nothing wrong with being ambitious as an organization (in fact that is what makes organizations grow) but being ignorant of a company’s capability when considering expansion is a grave business sin that no one should ever take lightly – remember that market forces are friendly but unforgiving!!

Symptoms and Signs of Overtrading

• Rapid growth: It is the dream of every business venture to grow. However, it becomes a problem when the growth is too rapid. Rapid growth is relative. So rapid growth in this context is when a company moves so quickly that it struggles to keep up with the additional responsibilities that comes with growth. Once the situation explained here occurs, it sends a red flag that the business has started overtrading. Rapid growth is the most common symptom of overtrading.

• Small profit margin: Another symptom of overtrading is when a business consistently has tiny gross profit margin. Notice that I said GROSS margin and not NET margin. A business must at least be steadily growing its gross margin or contribution margin. It is ok to start out with making losses but the most important thing is that there is improvement. A growing business that is not seeing significant improvement in its gross margin is showing a sign of overtrading

• Shortage of cash: Cash is always king in any economic endeavor. Any businesses that is in shortage of cash is showing a sign of overtrading and may soon missing out on opportunities as a result of shortage of cash. Shortage of cash is a major symptom of overtrading that should not be ignored for any reason. A profitable business without cash will simply go underground, just a matter of time. I wrote a piece on how to improve the cash flow of law firms, you can have a look as tips there are invaluable.

• Over reliant on loan: There is no rule that says a company cannot operate on borrowed funds. In fact, almost all business has one form of loan or other – at least for tax planning purpose. However, overly relying on loan to finance virtually every activity of a business is a time bomb waiting to explode. Depending on the kind of loan, the provider of the fund may come knocking unexpectedly demanding repayment.

• Growing number of unhappy suppliers: This is usually a fallout of many factors. As a result of continuously not meeting obligations, the number of unhappy suppliers will continue to increase. Similarly, an unusually large number of unhappy employees is also a sign of overtrading.

• Increased customer complaint: Customers can sometimes be insatiable. However, constantly not being able to deliver on agreed deliverables aggravates the dissatisfaction thereby increasing the number of complaints beyond normal level. I mostly check review sites to have a glimpse of the reason(s) why customers complain and this will help sieve out genuine complaints from the number customers’ complaints before concluding whether the complaints are symptom of overtrading or not.

• Deteriorating ratios: Once the standard liquidity ratios starts to deteriorate, one should be on the lookout for other symptoms and signs of overtrading. The importance of ratio analysis during business analysis cannot be overemphasized.

• Inability to meet obligations on a frequent basis: a major symptom of overtrading is when a business continually fails to meet with normal day to day financial obligations. A good example is when a business takes too long to pay for goods and services. This is technically known as Increased Debtors Day. For some reasons or the other, a pay or two may be missed but decision makers should start asking serious questions as soon as this becomes a regular habit.

• Key financial staff leaving: Finance and accounting department of any business that is overtrading are the first to start leaving. This is because they have firsthand information on the financial activities of the company. Ignore this sign at your peril.

How to Avoid Overtrading

• Proper use of feasibility report: The proper use of feasibility report and business plan can help highlight potential financing gap that might arise when making projections. It is part of the functions of management to make projections and forecasts, the output of a well written feasibility report goes a long way in assisting management in this function.

• Proper strategic planning: power without control they say is dangerous. Strategic planning is the control that is needed over the power of rapid expansion and growth. Strategic planning amongst other things deals with reckless expansion all in the name of investing.

• Application of suitable working capital management: Proper deployment of working capital is one way of ameliorating the effects of overtrading. Payables management for example can help a business obtain more favorable payment terms without necessarily hurting the reputation of the organization.

• Getting quality financial advice: Another reason why most small businesses fail is because they tend to want to do everything all by themselves. A firm understanding of the fundamentals investment is a major take away from interacting with a professional financial adviser.

• Proper use of credit control function: Make no mistake about this. There is no other sure fire way of overtrading than this. To what end if a business cannot collect monies that are due from her customers?

I am not saying that small businesses should break the bank just to have a credit control department. What I am saying is that at least someone should be responsible for the function of collecting monies that are owed to the company when it is due.

Not having a functional credit control function tells a lot. The company might just be dolling out sales and no one cares to collect the money back. This is a major sign of overtrading for me.

• Appropriately match finance: Most small business always fall victim of using the wrong kind of finance to finance their business. Using a short term fund for example to finance a long term business is a huge mistake that has caused a lot of financial frictions, therefore, is a sign or symptom of overtrading. You can have a look at my earlier article on sources of funds or finance for SME to see what options are available to you.

• Deploy optimal stock management technique: a lot of cash that could otherwise be used for other profitable ventures are ignorantly tied down on stock if the optimal stock level is not maintained. This is where knowledge about using working capital management to release funds is invaluable. I often cringe when I see companies pilling up items (stocks and consumables) that are needed immediately all in the name of trying to take advantage of one discount or the other without firstly doing their due diligence to determine if the company is financially better off or worse by taking that decision to buy in bulk.

Consequences and Dangers of Overtrading

In my article on dangers of high level of gearing, I extensively talked about the many bad things that can happen to a business that is doing things so quickly. I encourage you to have a look at the above hyperlinked article as this post on symptoms and signs of overtrading is getting too long already.