Overtrading takes place when a business accepts work and tries to complete it, but finds that fulfilment requires greater resources (ie cash, people, stock) than are available. This can be caused by unforeseen events such as:
- manufacturing or delivery taking longer than anticipated, resulting in cashflow being impaired
- customers making late payments
- rising prices of stock or machinery, which results in overspending by the business
Overtrading is a common problem, and it often happens to recent start-ups and rapidly expanding businesses. Cash often has to leave the business before more cash comes into it. For example, wages and salaries are usually payable weekly or monthly, and there may be other expenses that need to be met promptly, such as telephone bills and rent.
Although you may pay suppliers on credit, your customers may also pay you on credit. It doesn't take much to upset the balance.
It is also possible to run out of cash, even if your customers pay cash and do not have credit accounts. For example, you may have to pay suppliers quickly, perhaps even in advance, or you may have to hold stock for a long time. What matters is the amount of working capital and the timing of cash coming in and going out of the business.
Working capital is the difference between current assets and current liabilities. In the following example, working capital, or net current assets, amounts to £3,000.
|Debtors (owing by customers)||37,000|
|Creditors (owing to suppliers)||71,000|
|Net current assets||3,000|
Whether or not £3,000 is sufficient working capital depends on the circumstances of the business.
For further information see assessing your cash needs: assets and liabilities.