Bootstrapping too far: the dangers of overtrading
As entrepreneurs, it can be tempting to take every piece of work or contract we are offered. It’s exciting to see sales growing and growing each month, or week; but sometimes this can be a bad thing. Often, companies that are experiencing rapid growth can be at risk of overtrading.
Before I started my own company, I spent five years dealing with businesses in financial difficulty. There were a few successful turnarounds, but more often than not I saw promising business in the position of having taken on far too much work that they just couldn’t handle. In spite everyone’s best efforts, they usually ended up in liquidation.
Overtrading means carrying out too large a volume of trading in relation to the amount of long-term reserves in the business. A business that is overtrading doesn’t have enough capital for the amount of trading it’s carrying out.
How do you know if you’re overtrading?
- High rate of sales growth
- Low profitability – Are you reducing your gross profit margin to increase your sales? Are your expenses getting too high (e.g. administration costs) in relation to the increase in sales.
- Insufficient reserves – Are retained profits low?
- Large increase in inventory and trade receivables – Systems that worked well to control inventory and receivables may not work efficiently with a larger business. Inventory takes longer to clear and collections take longer.
- Financing the company using current liabilities – Are you taking much longer to pay suppliers, or is your overdraft increasing significantly?
Why is overtrading a problem?
In a word, insolvency. If your sales keep growing, and your company cannot finance that growth from its own resources, your bank may refuse credit and suppliers may refuse to deal with you. Also, suppliers that provide you with goods on credit may get frustrated and stop supplying you with the key products you need to continue trading.
If your company can’t pay its bills and invoices as they fall due, you may be insolvent. All of this could be because your company has inadequate liquidity due to insufficient long-term capital funding and reserves.
How to fix overtrading
There are two key ways to reduce the risk of insolvency by overtrading, namely:
- Increase your capital: Take on additional investment or long-term borrowings.
- Reduce the volume of business you’re conducting: Although this sounds counter-intuitive, if your business can’t support the level of business you’re currently getting, it’s a good idea to slow things down a little. Focus on more profitable contracts or pieces of work. This will allow your company to increase its reserves in a timely manner, and go for the bigger jobs when it has the resources to take them on comfortably. Use this time to plan out how you will cope with larger quantities of work, so that your costs don’t dramatically increase with additional sales.
Whatever method you do take, make sure you keep your bankers and suppliers on side at all times. Because no remedial action will be enough if they decide to pull the plug.