Overtrading indicators and solutions
What is overtrading situation?
Overtrading arises when a company attempts to expand too rapidly without
sufficient long-term capital. Consequently, the company finds itself
struggling to sustain a high volume of trade with its limited financial
resources.
The indicators of overtrading are as follows.
(a) There is a rapid surge in turnover.
(b) The volume of current assets, and possibly non-current assets,
experiences a rapid increase. This may lead to a slowdown in inventory
turnover and accounts receivable turnover, resulting in a greater rate of
increase in inventories and accounts receivable compared to sales.
(c) There is only a marginal increase in proprietors' capital, primarily
through retained profits. The majority of the increase in assets is financed
through credit, particularly:
(i) Trade accounts payable - the payment period to accounts payable is likely
to extend.
(ii) A bank overdraft, which often reaches or even surpasses the limit set by
the bank.
(d) Certain debt ratios and liquidity ratios undergo significant changes.
(i) The proportion of total assets financed by proprietors' capital decreases,
while the proportion financed by credit increases.
(ii) The current ratio and the quick ratio decline.
(iii) The business may face a liquidity deficit, meaning that current liabilities
exceed current assets.
What is overtrading situation?
Overtrading arises when a company attempts to expand too rapidly without
sufficient long-term capital. Consequently, the company finds itself
struggling to sustain a high volume of trade with its limited financial
resources.
The indicators of overtrading are as follows.
(a) There is a rapid surge in turnover.
(b) The volume of current assets, and possibly non-current assets,
experiences a rapid increase. This may lead to a slowdown in inventory
turnover and accounts receivable turnover, resulting in a greater rate of
increase in inventories and accounts receivable compared to sales.
(c) There is only a marginal increase in proprietors' capital, primarily
through retained profits. The majority of the increase in assets is financed
through credit, particularly:
(i) Trade accounts payable - the payment period to accounts payable is likely
to extend.
(ii) A bank overdraft, which often reaches or even surpasses the limit set by
the bank.
(d) Certain debt ratios and liquidity ratios undergo significant changes.
(i) The proportion of total assets financed by proprietors' capital decreases,
while the proportion financed by credit increases.
(ii) The current ratio and the quick ratio decline.
(iii) The business may face a liquidity deficit, meaning that current liabilities
exceed current assets.
