Overtrading

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Risks

There are two main risks of not monitoring working capital:

  1. Over-capitalisation

  2. Overtrading

Overtrading or undercapitalisation arises when a company has too little capital to support its level of business activity.

Difficulties with liquidity may arise as an overtrading company may have insufficient capital to meet its liabilities as they fall due.

Overtrading

  • Is often associated with a rapid increase in turnover.  

    Investment in working capital does not match the increase in sales.

  • Could be indicated by a deterioration in inventory days. 

    Possibly because of stockpiling in anticipation of a further increase in turnover, leading to an increase in operating costs.

  • Could also be indicated by deterioration in receivables days, possibly due to a relaxation of credit terms.

    As the liquidity problem associated with overtrading deepens, the overtrading company increases its reliance on short-term sources of finance, including overdraft, trade payables and leasing.

  • Can also be indicated by decreases in the current ratio and the quick ratio.

Over-capitalisation

Over-capitalisation means that an entity has an excess of working capital.
Entities that carry excessive inventories, receivables and cash with few payables have over-
invested in current assets. 

This presents an opportunity cost since such resources could be used to generate returns elsewhere in the entity.

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