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.
However, while it is sometimes easy to spot a struggling company, those that are overtrading will often appear to be doing ok — or even 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 when a company takes on more business than it can handle. If an organisation accepts a larger order than normal or takes on new clients, it will have to expend greater resources on things like manufacturing, hiring extra staff, or renting office and storage space.
To cover these costs without borrowing money, the company will need one of two things: enough cash to make the extra payments, or a payment structure that allows it to pay for the extra resources after receiving money from buyers.
If the company can’t do either of these, it may have to dig into its overdraft and survive on loans and credit. While this may work out ok initially, if a buyer pays late or if there is a sudden increase in costs then issues can arise.
The main problem for other companies is that, on the face of it, overtrading companies may appear healthy. They are likely to have plenty of orders and may be growing at a rapid rate. However, if you fail to spot a company that is overtrading, your business could be in trouble.
How Do Companies Get into Overtrading Trouble?
As mentioned above, companies get into trouble by taking on more business than they can handle. Here are two common causes of overtrading:
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.
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 company 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 and business credit checks.
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.
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.
To discuss how Red Flag Alert can be deployed in your business to greatly minimise the risk of bad debt, get on touch with Richard West on email@example.com or 0344 412 6699.