Articles » Latest Articles

How to Spot a Company that is Overtrading

Dec 18, 2018 Red Flag Alert Updated On: August 14, 2023
How to Spot a Company that is Overtrading

Businesses that are overtrading may have problems making payments or fulfilling orders. For this reason, you need to be cautious when dealing with overtrading clients.

Overtrading is a common cause of insolvency in the UK and as such generates a large amount of bad debt each year. Unlike many other causes of insolvency an overtrading company can look, on the surface, like it is not only doing well but thriving.

This article will look at what overtrading is, as well as let you know how Red Flag Alert can help you discover if a company you are about to do business with is overtrading.

What is Overtrading?

Overtrading is where a company sells more than it has the resources to deliver upon, these resources can be such as cash, staff, equipment, production capacity or supply. This is usually done when a company is expanding too rapidly and many directors fall into the trap of equating more sales with more success and therefore profit.

A company that has taken on more than it can deliver must then find a way to meet these extra requirements. This usually involves generating debt as the necessary resources are purchased. If a company continues to overtrade then eventually it will collapse into insolvency despite outwardly looking like a high growth company.

A company can overtrade by taking out loans to cover the costs of sales it did not have the stock or cash to supply but can also overtrade by agreeing to sales/jobs that they do not have the infrastructure to make. For example they may have to hire short term agency staff that may not be properly trained or hire or even purchase new equipment.

Essentially, by overtrading companies increase the costs of making sales, increase debts and reduce profitability and cash reserves.

A simplified example of overtrading is:

A company sells TVs that it buys from suppliers for £100 and sells for £150. It has 10 TVs in stock and £1000 in the bank. It sells all 10 TVs on 30 day credit. It purchases the 10 TVs with the £1000 in the bank and sends them to the customer.

It now has no stock and no cash reserves but will receive £1500 at the end of the month. The next day it gets takes an order for 20 TVs on 30 day credit. It must then borrow £2000 to make the purchase from its supplier. It must pay £200 interest on the loan and a further £100 if it does not repay in 30 days.

The company is now making less profit on the 20 TVs which will be further reduced if the customer is late in paying.

As a one off this is not necessarily damaging but if done repeatedly decreased profit margins and accruing interest leave a business vulnerable to market fluctuations and unexpected costs.

Effects of Overtrading 

As mentioned above, repeated overtrading drives down profit margins, increases liabilities and leads to smaller cash reserves. As a company falls further into this situation they become increasingly vulnerable to any fluctuations in business operations; such as late payments from customers, bad debts from insolvent customers, breakdown of equipment or rising costs.

Also, if a company is already heavily financed then it may struggle to find a lender to help it through should any of these happen.

If a company takes on more work than it is capable of doing at once then it will most likely be late in delivering some or all of its contracts. This can cause reputational damage and decrease consumer confidence, which leads to a decrease in future business.

Whilst suppliers will initially be pleased that one of their customers is making larger orders most will be experienced in spotting an overtrading company. If they do they are far less likely to extend favourable credit terms and may cease offering any credit at all. Any major interruption to a company’s supply chain can have serious short and long term effects on its ability to generate revenue and meet their financial commitments.

Overtrading companies quickly enter a situation where they are surviving month to month. Revenue coming in is needed to pay creditors as quickly as it enters and a decreasing amount can be retained as profits. In this way any interruption of business can quickly make them unable to repay creditors on time and interest and late fees can quickly pile up. Once a company is unable to pay its debts it is insolvent and at risk of being wound up.

How Do Companies Get into Overtrading Trouble?

Companies get into trouble by taking on more business than they can handle. Here are two common causes of overtrading:

Seasonal Trends

It’s not hard to see how seasonal trends could lead to overtrading. Busy seasons can give businesses the opportunity to take on a lot of extra work. However, it can be problematic if this extra work isn’t planned for and managed well.

Companies Overstretching

When companies expand into other areas, they often put themselves at risk of overstretching resources. Despite taking on more projects and potentially having more money flowing into the company than ever before, they can be at serious risk of overtrading.

One such example is Carillion, which, before its collapse, had 42,000 employees worldwide in places as far apart as the UK, Canada, and the Middle East. Just over a year before the company began the liquidation process in January 2018, it had a market value of £1 billion.

However, the company started to have problems, including late payments, fines due to delivering late on projects, and contracts being unprofitable. In the end, the company’s banks decided not to provide more finance and Carillion had to ask the government for a bailout. This was turned down, leading to the company being placed into liquidation.

Dangers of Overtrading

The main danger of overtrading is that it can ultimately lead to liquidation. However, before that, companies are likely to experience some of the following:

Having to Borrow to Cover Costs

When companies take on more trade they will often have to spend more money. This can lead to them not having enough cash to cover costs. If companies don’t have enough cash, they will have to find other ways to pay for their additional expenses – such as borrowing.

Companies often think that they can pay off the loans when the extra payments come in. However, buyers paying late or sudden increases in costs can prevent companies from repaying loans.

Not being able to pay loans on time can lead to higher interest payments, which is one of many things that can lead to the following point.

A Smaller Profit Margin

When expenses begin to creep up, the amount of profit a company can make on its new deals goes down. Additionally, when things get desperate, companies will often begin to make decisions that reduce profit margin – such as cutting prices.

In the case of Carillion, overtrading led to late delivery on some of its contracts, which incurred penalties that further reduced the amount of profit it was able to make.

Loss of Support of the Businesses the Company Deals With

If overtrading leads to the business being late with deliveries, buyers will begin to lose faith in the company. This could eventually lead them to go elsewhere for their business.

Likewise, if cash flow problems are causing the business to be late with payments, suppliers may decide they either simply no longer want to deal with the business, or they demand payment up front. Finally, if the company is consistently increasing the amount it borrows, banks will eventually lose trust in the company’s ability to pay the money back.

If a business does go into liquidation, then as a supplier you will be at the end of the queue behind all the preferred creditors, fixed charge holders, floating charge holders. Furthermore, under new proposals due to take effect in 2020, HMRC will also be before you in this queue – nine pence on the pound would be a good return which you need to avoid at all costs.

Red Flag Alert – A Key Tool

Red Flag Alert is the most detailed business intelligence database in the UK; with detailed information on every business updated daily, it is the ideal place to spot overtrading.

Red Flag Alert allocates a health rating to every business in the UK. This rating is updated daily and includes all new information. Businesses all over the UK build their credit scoring decisions based on Red Flag Alert data.

Red Flag Alert can quickly help you identify overtrading:

  • Using the financial health rating system is a great start. The health rating will factor in indicators of overtrading.

If you want to dig deeper into a single business, you can check out these key indicators:

  • Cash ratios help determine if there is adequate working capital in the business. In particular, the current ratio and the quick ratio, both of which consider the ability of a company to meet liabilities when they fall due.
  • Current liability levels, an increase of which is a possible symptom of overtrading, particularly if combined with shrinking working capital, or sustained increases in inventory.
  • Capital adequacy is used to determine if a business is equipped to mitigate against a period of potential overtrading.
  • Age of the business is a factor, but overtrading doesn’t just happen in newer businesses; overtrading can also happen in more established businesses.

Take Action

Once you ascertain that a client may be overtrading and is at risk of insolvency, there is action you can take.

  • Tighten up payment terms so the business owes you the minimum possible amount.
  • Increase margins: overtrading customers might still accept adverse terms because there might not be anyone else willing to supply.
  • Decrease reliance on that customer.
  • Only deliver the bare minimum of stock, and link deliveries to payments.
  • There may also be accounting opportunities, so if for instance you currently pay VAT on the accrual basis, check to see if you qualify for submitting return on a cash basis. Businesses can recover unpaid VAT in an insolvency situation, but this is not always fast.

The most important factor here is to be aware that clients are potentially in trouble – Red Flag Alert gives you these assurances and allows you to put contingency plans in place.

Free Consultation

Red Flag Alert utilises a variety of sources for our scoring system to give you a comprehensive analysis of a company. We won’t just show you the list of insolvent companies but also those who are at high risk of insolvency. Red Flag Alert is designed to protect your business against a multitude of risks. Learn more about our insolvency risk scoring solution or book a demo to see how our score works.


Published by Red Flag Alert December 18, 2018

Stay informed

Sign up to receive expert insights direct to your inbox.