Surely if you sell more, you’ll have lots of money coming in. That’s good news, isn’t it?

Not necessarily.

There is something called overtrading which is a serious problem to watch out for. Overtrading occurs when a business expands its operations too quickly, selling more than its underlying resources can support – essentially running out of cash.

Here’s an example. Your business sells lamps at £100 per unit. You buy in lamps from a supplier at £70 per unit. You make £30 profit per lamp.

At the beginning of the month, you have £7,000 in your bank account. On day one, you get an order for 100 lamps, producing a £3,000 profit. But you have to spend £7,000 on lamps from your supplier, immediately paying out all the cash in your bank account.

The customer has purchased on 30-day terms and their £10,000 invoice will not be paid to you until the end of the month. You therefore have an empty bank account for a whole month.

On day two, another order for 100 lamps comes in. However, you don’t have any money to pay your supplier for the second order until the end of the month.

At this point you are overtrading – selling more than you can deliver – and your business has no cash. Most probably you will lose your new order to a competitor.

There are obvious ways to address this problem: a bank overdraft or credit terms with the supplier, for example. However, the cost of overdrafts and other business running costs can get you into a very tight position between liquidity and running out of cash.

Here are five danger signs that you may be overtrading.

1. You need to borrow money to get through each month

Using an overdraft occasionally is fine and using a business loan for a long-term capital project (eg: improvements to your business premises) is acceptable, but when you need to borrow cash regularly, it’s a danger sign. Business can regularly produce unexpected costs and if your company doesn’t have the cash resources to call on, it could be a serious problem. Banks are very aware of businesses running up large debts and failing and that’s why they will not offer business credit without the business owners putting up personal assets for security. The question is do you want to risk your home to run a business with tight finances?

2. Your profit margins are low

A lot of businesses operate in very competitive markets, which usually has the effect of pushing down selling prices. This drives down profit margins and can negatively impact on cash flow. So you work very hard to get the sale but then you have to juggle the cash to keep your head above water.

3. Customers are making late payments

The current recession has impacted businesses in many different ways and one of these is a delay in payments from customers. This can be the final straw for a business which already has a finely balanced cash flow. It is essential that all your customers are clear what your payment terms are. Also don’t be afraid to chase customers for payment when it’s overdue. It’s money that’s yours and you are not your customers’ banker!

4. A key supplier is getting nervous

Your key suppliers might know you have a problem before you do! They will be very pleased that the size of the orders you are placing with them continues to increase but they will be dismayed as your payments slow down. If you have problems with suppliers or can see difficulties on the horizon, talk with them as soon as possible. Poor or lack of communication makes people nervous.

5. Your accountant’s face has gone green

Your accountant could be the best friend you have ever had. A good one can identify the warning signs of overtrading before you do. Listen to them. They can advise and help you implement a plan to manage and avoid it in future. The answer to all these issues around overtrading is be aware, anticipate and plan.

By Chris Taysom of My Business FD

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