It happens when a business tries to do too much too quickly with too little long-term capital, so that it is trying to support too large a volume of trade with the capital resources at its disposal. Even if an overtrading business operates at a profit, it could easily run into serious trouble because it is short of money. Such liquidity troubles stem from the fact that it does not have enough capital to provide the cash to pay its debts as they fall due.
There are some symptoms of overtrading:
(1) There is rapid increase in sales;
(2) There is rapid increase in the volume of current assets and possible non-current assets. Inventory turnover and account receivable turnover might slow down, in which the rate of increase in inventories and account receivable would even greater than the rate of increase in sales;
(3) Small increase in capital (perhaps through retained profits). Most of the increase in assets is financed by credit especially trade account payable (the payment period to accounts payable is likely to lengthen) and bank overdraft (often reaches or even exceeds the limit of the facilities agreed by the bank);
(4) Some debt ratios and liquidity ratios alter dramatically.
Solutions to reduce the degree of overtrading:
(1) New capital from the shareholders could be injected;
(2) Better control could be applied to inventories and accounts receivable. Companies could give up some ambitious plans for increased sakes and more non-current asset purchases until the business has had time to build up its capital base with retained profits.
