The desire of every business is to expand to meet the growing needs of the market and customers.
Although growth holds many advantages for a business, one must beware of the potential dangers of growth (Hisrich & Peters, 2008: 488).
Possible dangers associated with growth and expansion include: financial strain involving issues of cash flow management which can result in liquidity problems; disruptions in the supply chain as a result of inability to manage huge volumes of activities; and the need to spread resources across a wider area of the business which may lead to dilution of strategic focus.
Expansion without considering the working capital capacity of the business can therefore pose a serious threat to the survival of a business.
The concept of overtrading, also known as undercapitalisation, occurs when a company is expanding beyond the level of its working capital.
That is, the company tries to support large volume of trade with insufficient working capital base.
Causes of Overtrading
There are several factors that can lead an entity into the unfortunate situation of overtrading. Some of which are:
Inability to manage growth properly: every business entity has the desire to expand and eventually enjoy economies of scale advantages associated with expansion.
Managing business expansion is a whole issue on its own. An entity that is not conscious of the adverse effects of expansion may land in the unfortunate position of overtrading.
Intense competitive rivalry: A business entity operating in a highly competitive industry may always want to remain at a strong competitive level.
As entities struggle to gain market share and consolidate their market leader or market challenger positions, overtrading may become inevitable.
Over-optimism and over-ambition from business owners about their growth prospects may mean attempting to take on more business than the working capital capacity of the business.
Inappropriate cash management practices: Poor cash management practices will affect the liquidity position of a business. As the business expands and there are not enough liquid assets to support operations, overtrading may set in.
Favourable economic conditions: generally, when an economy is booming and there are other favourable economic factors such as low interest rates on borrowed funds, low inflation rate and increase in demand for goods and services, businesses may want to take advantage of the situation and expand their operations.
One negative consequence that a business may face, if the expansion is not carefully managed, is overtrading.
Symptoms of Overtrading
Identifiable symptoms of businesses suffering from overtrading include:
Rapid growth in sales over a relatively short time outpacing the capacity and ability of the business to handle.
This may lead to other negative operational consequences such as production of defective products that fall short of the desired quality, increase in error rates, huge workload on staff, frequent and persistent customer complaints, increase in rejects and refunds made to customers.
Deteriorating inventory turnover and receivables’ ratio: As operations expand beyond the working capital requirements of a business, it becomes difficult to manage inventory and receivables.
The delay in receiving money from customers, coupled with poor inventory turnover, can place a business in a serious liquidity trap.
Increasing use of trade credit to finance growth in current assets: businesses in the web of overtrading generally face serious liquidity problems.
Meeting short-term obligations as and when they fall due becomes a problem.
The way to get inventory is to rely on trade credit. Eventually, the goodwill from suppliers may be lost.
Declining liquidity ratios: liquidity ratios such as the current ratio, acid test ratio and cash ratio will be falling below acceptable levels.
Declining profitability: As a business expands beyond its working capital requirements, there is a need to incur further, unplanned and unexpected costs to sustain the growth and expansion, leading to a reduction in profitability.
Strategies to deal with overtrading
A business caught up in the web of overtrading must adopt the following strategies to deal with it so as to eliminate completely, or minimise, the negative effects of overtrading:
Introduce new capital, possibly, by injecting new equity into the business: business owners faced with overtrading must quickly assess the additional working capital requirement needed to match the scale of operations and inject the needed capital into the business.
Improve working capital management by reviewing credit policies and also chasing or pursuing overdue accounts receivable.
This may include the introduction of early payment discounts, reviewing credit days to shorten the receivables collection period and assessing the cost of additional finance required for any increase in volume of accounts receivable or the savings from a reduction in accounts receivable.
Implementing effective inventory management to avoid overstocking of items. Inventory control levels such as the reorder level, the maximum level and the minimum level must be carefully evaluated and set at levels to match operations.
A Just-in-Time (JIT) inventory management system can also be considered.
Reduce business activities to match the level of working capital.
This involves a kind of retrenchment strategy whereby the scope and scale of operations are reduced, significant cost reduction undertaken, reengineering of business processes to improve efficiency and ensure that the business becomes financially stable and financially adaptable.
Stephen Mensah Dzodzodzi (PhD, CA, Ch.EE, Ch.PE, CGMA) is a chartered petroleum economist, a tax and management consultant and CEO of Centre for Professional Studies, Ho.
email: stephenmensah2016@yahoo.com.
Charles Ekornunye Ansah is a member of the Chartered Institute of Tax Law and Forensic Accountants – Ghana (CITLFAG), and an Employee of the Ghana TVET Service. email: ekornunye@gmail.com.
