RICHARD HOLDEN OF LLOYDS BANKING GROUP EXPLAINS HOW TO AVOID OVERTRADING

There is an age old problem known as overtrading that creeps up on you just when sales are growing rapidly.

Overtrading means selling more than you can handle as a business and occurs when a company has insufficient working capital to sustain its level of trading. This can happen even in profitable companies and often occurs when businesses expand their operations too aggressively. Overtraded companies can eventually face liquidity problems and run out of working capital.

INVOICES PAID LATE
Typically, overtrading sneaks up on you when your invoices are being paid late or when sales grow too quickly. You think your business is trading well, then you suddenly find you no longer have cash in the bank to pay your suppliers or enough working capital to pay wages, bills and rent, even though you have sold more than enough to cover your costs.

Rising economic optimism may result in some businesses overreaching themselves and ending up with serious cash flow problems. Running out of cash causes too many promising start-ups to fail and the most tragic thing is that cash flow difficulties are often avoidable.

Effective debt management and credit control can help you avoid overtrading by ensuring you get paid more efficiently and have the cash to pay suppliers and staff. One way you can help prevent overtrading is by keeping a tight control of the money you have going out of your business.

You could also consider:
• Producing regular cash flow projections.
• Ensuring your budget reflects seasonal sales variations.
• Injecting additional capital.
• Reducing the amount of product you hold in stock.
• Reducing how long you hold stock for.
• Renegotiating better terms with your suppliers.
• Reducing the amount you personally draw from the business.
• Leasing your assets or buying them on hire purchase.
• Negotiating staged payments or deposits for services/products you offer.
• Raising invoices immediately and being clear about payment terms.
• Implementing a system to chase payments, from gentle reminders through to firm warnings.
• Offering discounts to customers who pay invoices early, but keep in mind your profit margins.
• Regularly checking existing customers’ credit ratings and their payment history.
• Cutting costs and being more efficient.

WARNING SIGNS
Crucially, you need to watch out for the key overtrading warning signs, which may include payment terms slipping, increased use of your overdraft facility, regularly paying your suppliers late and the drop in quality of your goods or services.  

Invoice discounting is an effective solution to overtrading. It involves borrowing cash against your invoices, while staying in control of debt recovery. Factoring is a similar funding option, but involves the funding provider directly recovering your customers’ outstanding debts. If you think your business is in danger of overtrading, speak to your bank manager as soon as possible to find a solution.

OVERTRADING EXAMPLE
• You have a starting balance of £5,000 in your bank account.
• You sell your product at £50 and it costs you £25 from your supplier, resulting in £25 profit per item.
• In week one you sell 60 items, generating £3,000 sales and £1,500 potential profit.
• Your supplier delivers in one week, but requires cash on delivery.
• You pay your supplier £1,500 for the first order and deliver to your client, who wants payment terms of 14 days, so you raise an invoice of £3,000 and wait to be paid.
• In week two you sell a further 120 items, generating sales of £6,000 and potential profit of £3,000.
• Your supplier delivers the second order and you pay them £3,000 and release the goods to your client, raising invoices for a further £6,000.
• In week three you sell 160 items, generating £8,000 and potential profit of £4,000.
• Now here’s the problem: your supplier wants paying £4,000 before it delivers the next order, but you only have £500 in your bank account. You don’t have enough cash to pay your supplier, even if your client pays the week one sales invoice of £3,000 on time.
• You have sold £17,000-worth of goods with a potential profit of £8,500, but due to overtrading have run out of working capital.

Richard Holden is head of franchising at LLoyds Banking Group.

For more information visit www.lloydsbank.com/franchising