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  Financial Ratios and the Problem of Overtrading

Introduction to Financial Ratios and the Problem of Overtrading

Overtrading takes place in which a business is operating at a level of activity that cannot be supported through the amount of finance that has been committed. For instance, the business might have insufficient finance to fund the level of trade receivables and inventories essential for the level of sales revenue which it is achieving. This condition generally imitates a poor level of financial control over the business. The causes for overtrading are diverse.

It may take place:

  • in young, expanding businesses which fail to prepare sufficiently for the rapid increase in demand for their goods or services;
  • in businesses in which the managers might have misjudged the level of supposed sales demand or have failed to control escalating project costs;
  • the result of a fall in the value of money (inflation), causing more finance to have to be committed to inventories and trade receivables, even in which there is no expansion in the real volume of trade;
  • in which the owners are not able to inject further funds into the business themselves and/or they cannot convince others to invest in the business.

Anything the reason, the troubles that it brings must be dealt with if the business is to carry on over the longer term.

Overtrading results in liquidity problems like exceeding borrowing limits, or slow repayment of borrowings and trade payables. It can also effect in suppliers along withholding supplies, thus making it hard to meet customer requirements. The managers of the business may be forced to direct all of their attempts to dealing with instant and pressing problems, like finding cash to meet interest charges that due or paying wages. Longer-term planning becomes hard as managers spend their time going from crisis to crisis. Finally, the business may fail since it cannot meet its maturing obligations.

A business must ensure that the finance available is reliable with the level of operations to deal with the overtrading problem. So, if a business which is overtrading is unable to increase new finance, it should cut back its level of operations in line along with the finance available. Even though this might mean lost sales and lost profits in the short term, it might be essential to make sure survival over the longer term.

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