How your business can avoid overtrading

Overtrading happens when a business can’t meet the demand for its products or services. It can lead to starting a project that you can’t finish, or delivering a service below your usual standards.

Overtrading can have an impact on the reputation of your business and in the worst cases lead to financial problems. Read our guide for tips on how to spot the signs of overtrading, plus how to avoid or overcome it.

• What is CPD – and why is it important?
• What is SWOT analysis?
• What is EBITDA?
• What is professional indemnity insurance?

What is overtrading?

The overtrading business definition is when a business can’t fulfil its orders so it doesn’t get paid. It could be down to a range of factors including manufacturing issues, lack of staff, or shortage of stock.

Overtrading can happen to any business and in the worst cases could lead to insolvency. Businesses can reduce the chances of overtrading by managing their cash flow effectively and making sure they have the structure in place to fulfil rising demand as they grow.

How can overtrading lead to business failure?

Overtrading can lead to a business’s finances spiralling out of control. If money is leaving a company before it comes in, the likelihood is that it won’t be able to keep up with its outgoings.

To try and earn more money, a business may continue to accept orders that it can’t fulfil. This kind of overtrading can lead to unbalanced finances, affecting payment of staff or utility bills.

As well as a difficult working environment for staff, not having the resources to meet demand will also impact customers.

In the worst cases, overtrading businesses could face legal action, whether that’s from suppliers they’ve failed to pay or clients they’ve not serviced.

It can be very difficult for businesses to recover from this position, often leading to insolvency or closure.

What is overtrading and undertrading?

Undertrading is the opposite of overtrading. Instead of not having the finances to meet demand (overtrading), an undertrading business has healthy cash reserves but isn’t using them effectively.

For example, the performance of a company that doesn’t reinvest its profits into retaining staff or developing its products could decline over time, putting its future financial stability in doubt.

Undertrading is usually caused by poor management and a lack of accountability. Companies with a solid structure and well-developed organisation chart are less likely to suffer from undertrading.

Companies that undertrade could also experience repetitional damage, or have a reduced chance of external investment such as venture capital or crowdfunding due to a perceived lack of ambition or innovation.

What are the signs of overtrading?

Depending on the sector your business operates in, the signs that you’re overtrading will be different. However, here are some of the most common experienced by all types of business:

• poor cash flow – if you haven’t planned for all costs, or don’t have the reserves to pay for unexpected ones, your ability to provide key products and services could be severely affected
• reduced profit margins – dipping profits could reflect a drop in demand or increase in competition. If profits drop, your cash flow could be affected
• borrowing money regularly – if you need to borrow cash to pay your staff and bills each month, this could be a sign your business isn’t sustainable anymore
• supplier issues – if the size or frequency of your orders drops because finances are tight, suppliers could get nervous and look to move away from working with your business

What are some overtrading examples?

A business takes on a range of new contracts but runs out of money to pay its suppliers. As a result, the suppliers stop delivering and the business can’t fulfil its orders. This leads to the business not getting paid by its clients, as well as reputational damage.

Over a period of time, the business will come under severe financial stress as it has debts to pay off and no money coming in.

Other examples of overtrading include:

• not having the space to keep stock that’s been ordered by clients
• long periods between payments mean you can’t keep up with expenses
• not having enough staff to service rising demand, slowing down your service

StratfordProductions/stock.adobe.com

How to avoid overtrading

As your business grows, the chances of overtrading increase. There are also external factors, such as the economy and demand in the sector you operate in, that you can’t control.

The main thing you can do to minimise the chances of overtrading affecting your business is to manage your finances effectively.

This means having a solid grasp of your cash flow, using a budget to manage income and expenses, and making sure your business’s assets equal its liabilities and equity with a balance sheet.

Here are some other things you can do to avoid overtrading:

• issue late payment letters – late payments can significantly disrupt your cash flow, meaning you may not be able to service other clients. Download our late payment letter template to increase your chances of getting paid on time
• carry out a PESTLE analysis – taking stock of the political, economic, social, technology, legal, and environmental factors affecting your business can help you to plan for the future. Read our PESTLE analysis guide to get started
• manage supply chains effectively – controlling the flow of products and materials you need to run your business can be challenging. That’s why getting to grips with supply chain management can increase your chances of being able to service demand

How to overcome overtrading

If your business is showing some of the overtrading signs outlined above, there are steps you can take to reduce the chances of things getting worse.

Here are some of the most effective ways to overcome overtrading:

• try invoice finance – this can be used to access cash if you’re waiting for payments from clients. Read our invoice finance guide for more information
• use hire purchase – spreading the cost of important equipment or assets like a business van can help to keep your spending down
• scale back growth – if you’re growing too quickly, keeping up with demand could be tricky. Improving processes and infrastructure first could help to secure your long-term future
• hire more staff – if you can’t keep up with demand or finish projects on time, growing your workforce could make a big difference
• change suppliers – supply chain issues could have a negative impact on your cash flow. If you’ve been having issues for a while, changing suppliers could help to get things moving again

Business finance is a complex topic, so remember to speak to a professional financial advisor or accountant if you’re not sure of anything.

Do you have any unanswered questions about overtrading? Let us know in the comments below.

littlewolf1989/stock.adobe.com