A tragedy of a competitive modern business environment is that occasionally a profitable firm will still find itself insolvent and unable to trade.
This phenomenon is known as ‘over-trading’ and is a pitfall that many new entrepreneurs discover the hard way.
Over-trading occurs when a firm expands too quickly compared to the amount of company capital and external finance. In other words, for the given level of cash it had at its disposal, it grew too large, too quickly.
To demonstrate how easy this is, consider the number of ways in which small business owners can be lured into overtrading:
- Placing large purchase orders to achieve economies of scale to save on the cost of shipping
- Opening additional venues to capitalise on the popularity of the brand
- Extending a shop into the lot next door to increase floorspace
- Adding new product ranges to provide more variety and increase the likelihood of repeat purchases
All of these decisions were made with an eye on revenues and profit, however, they each contain a couple of characteristics that should be red flags for over-trading.
- They’re cash-intensive – involving upfront cash payments
- There will be a delay before the outlay generates a positive cash return
For example, if a company purchases a few months’ worths of stock in a single order, it acknowledges that some of that stock will not be sold for several months. This means that the outlay to buy the stock will not be offset by revenue for an extended period, and therefore this will put pressure on the firm’s finances.
This isn’t to say that lightning-fast growth is impossible. Businesses can and do grow their turnover 50-fold or even 100-fold in a few years. But to do so they usually need access to the deep pockets of investors such as venture capital firms. VC partners understand the amount of cash required to scale up a business – particularly brick & mortar businesses such as restaurant groups which must invest in lots of equipment and premises to grow.
When entrepreneurs attempt to mirror the growth of firms like Airbnb without mirroring the financing, overtrading and bankruptcy can result.
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To stave off insolvency when a firm has overtraded, the following actions could be taken:
- Closure of least-cash generative branches to cease further outlays
- Laying off staff to reduce the wage bill
- Holding a sale with heavy discounts to quickly release cash tied up in stock
- Applying for additional loan finance to allow the firm to make payments to suppliers
- Cancelling purchase orders with suppliers where refunds are possible
The antidote to over-trading is downsizing the cost base of the business and freeing up the cash that has been tied up in assets that wouldn’t otherwise provide a cash return in a short space of time. This allows the firm to improve its net cash flow to something approximating the profit it makes on its established operations.
Over time, these profits can be retained within the company. This will increase the capital available to the firm to expand sustainably later.
