Growing too quickly can leave you over-stretched and without the resources you need to fulfil your commitments. Thankfully, if you know what overtrading is and how to spot it early, it's much easier to prevent it from happening.
"Businesses often start out with modest ambitions," says Andrew Gooadacre, Chief Executive Officer of the British Independent Retailers Association. "Then it goes better than expected and the owners become more ambitious and start to expand. This then becomes a critical phase of the business."
In this article, we'll discuss what overtrading really means - and how to spot it early before it starts to harm your small business.
What is overtrading?
Overtrading happens when a business expands too quickly without the resources it needs to support that growth. For example, a lack of cash, staff, or production capacity. This can mean the business is unable to deliver on its commitments to employees, suppliers and customers. Importantly, it can occur even when a business is profitable.
Common causes for overtrading
While overtrading can be caused by a combination of factors, some common triggers include:
- Making a big capital investment before revenue is generated.
- Late invoice payments from customers or clients. In fact, 24% of UK businesses say late payments threaten their survival.
- Accruing unexpected expenses.
- A sudden increase in demand or seasonal business trends.
- A sharp increase in stock.
- Incurring big costs on a long-term contract before the customer pays you: 60% of UK SMEs wait over 60 days for payment.
- Underestimating the cost of doing business.
How to spot the signs of overtrading
Cash flow is often a strong indicator of early problems. In Goodacre's experience, most businesses fail because of poor cash flow management rather than a lack of profits.
"Overtrading is a sad consequence of expansion often not being managed correctly and soon the cash flow becomes a real problem," Goodacre says. As businesses expand, cash flow management is "critical."
In the UK, around 12% of SMEs across sectors were expecting to experience cash flow problems in the second quarter of 2020 alone. The consequences can include having to borrow money or use a bank overdraft, paying suppliers late, unfulfilled orders, and a lack of cash for salaries or equipment.
Research shows that almost one in five small businesses has struggled with no cash in the bank, with about 18% having to use their overdraft. This can lead to damaged relationships, a tarnished reputation and a lack of sufficient cash for growth. In the worst cases, it can lead the business to fail.
5 ways to prevent the risk of overtrading
1. Manage your cash carefully
Small business owners in the UK lose an average of £26,000 by being forced to turn down work, specifically due to issues created by insufficient cash flow.
Consider using accounting software or asking your accountant to help you better manage and forecast your cash flow. Clear monthly data on your cash reserves will enable you to spot and plan around any shortfalls or seasonal trends that can otherwise lead to overtrading.
2. Lease instead of buying equipment
Leasing equipment, instead of purchasing it, can be a good way to avoid making big payments upfront. Instead, you can spread the costs over several months, leaving you with more cash to cover your other monthly payments. Leasing can also sometimes be cheaper than buying.
3. Reduce your stock levels
"Excessive stock increases the working capital your business needs," says Goodacre. "It is worth bringing in smart Electronic Point of Sale (EPOS) system to help with your stock management." An EPOS automatically tracks all your transactions in one place from goods brought in to sale out, so you can actively monitor and reduce stock levels according to demand.
4. Look at your business model
Minimise the risk of late invoice payments by re-evaluating your business model. For example, perhaps you could take more payments upfront, or you might consider moving to a subscription model to receive payments more regularly.
Automating your regular invoices will also help to ensure they're sent on time, increasing your chances of getting paid sooner rather than later.
5. Negotiate with suppliers
If your supplier payment terms aren't working for your business, consider negotiating by extending payment periods or even increasing payment frequency to help you better manage and project your cash flow.
"Ambition is good and must be encouraged," says Goodacre. Yet expansion needs to be carefully planned for and it's important to be aware of the potential for overtrading, so you can take steps to prevent it. That way, when growth opportunities come your way, you will be better equipped to take advantage of them.
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