Overtrading: a Worked Example

A business pays for its stock and wages before its customers pay it. The gap between the two is working capital, and it grows in proportion to sales: double the sales on the same terms and the business needs roughly double the money tied up in debtors and stock, less what suppliers fund. Profit replaces some of it, but profit arrives at the margin, a few cents in each dollar, while the working capital need grows by a much larger share of each dollar of new sales.

The symptoms come before the accounts show anything wrong. The overdraft sits at its limit and does not clear. Suppliers are paid later each month and some move the business to cash on delivery. GST, VAT or tax deducted from wages is paid late or put on an arrangement. The owner reports record sales and asks for a larger limit. Each of these is the business borrowing from someone, often without that creditor's agreement, to fund growth it has already committed to.

Stock and creditors are measured on cost of sales, debtors on sales, because that is what each one is built from. The cash conversion cycle compresses the three into one figure in days, which is useful for comparing years but hides which part moved. The funding gap is the number that matters to a lender: the part of the growth that profit will not pay for. What remains after any undrawn facility is the money still to be found. There are four ways to close it: more debt, more equity, slower growth, or better terms from customers or suppliers.

A commercial solar installer, constructed for this page like every figure in it, fits panels and batteries for farms, warehouses and builders. It has sales of US$12m at a gross margin of 30%, collects in 45 days, holds 75 days of imported panels and inverters, and pays suppliers in 30 days. It wins enough work to take sales to US$20m next year on the same terms. Its overdraft limit is US$1.0m, with US$0.4m drawn.

The installer makes more profit next year than this year and still runs out of facility by about US$0.6m. If nothing changes, that money comes from suppliers paid late and tax paid late, which is how overtrading usually shows itself to a lender. The 60-day line shows how sensitive the gap is: bigger customers often pay more slowly, and fifteen extra days across the ledger adds US$0.8m to the need. The last line shows the cheapest remedy, which is the one owners resist most. The margins, days and limits are the example's, not a market norm.

Overtrading is a description of a funding mismatch, not a legal category. A business can overtrade for a year and come through it with a new facility or fresh equity. It becomes a pressing legal question as the business nears the point where it cannot pay its debts as they fall due, and directors' duties differ by market: in New Zealand, sections 135 and 136 of the Companies Act 1993 bar a director from allowing the business to be carried on in a way likely to create a substantial risk of serious loss to creditors, or from agreeing to an obligation without reasonable grounds to believe the company can meet it, duties that apply whatever the balance sheet shows; in Australia, section 588G of the Corporations Act 2001 makes a director liable for a debt the company incurs while insolvent where there were reasonable grounds to suspect insolvency, subject to defences and a safe harbour; in the UK, section 214 of the Insolvency Act 1986 can make the director of a company in insolvent liquidation or administration contribute to its assets, if the director knew or ought to have concluded earlier that there was no reasonable prospect of avoiding that outcome and did not then take every step to minimise creditors' losses.

It also differs from a seasonal peak. A seasonal need rises and falls within the year and suits a revolving facility that clears; growth creates a need that stays, which is what temporary or permanent working capital separates.

DEFINED IN ONE PARAGRAPH → · TEMPORARY OR PERMANENT WORKING CAPITAL → · TAX ARREARS →

The request usually arrives as an overdraft increase, presented as temporary. A lender that recognises overtrading reframes it: the extra working capital is permanent for as long as the business stays at the higher level of sales, so it calls for funding that stays, whether a larger committed facility, a term loan, an invoice finance line that grows with the debtors, or equity from the owners. Lending it as a seasonal overdraft that is expected to clear, when it will not, sets up the next breach.

The lender's other lever is the plan. It asks for a monthly cash forecast through the growth, tests it at slower collections, and looks at the terms the new customers will actually pay on. It may ask for customer deposits on large jobs, see customer prepayments, or for growth to be phased. A borrower who brings that forecast with the request, rather than after the limit is hit, is asking a different question: how to fund a plan, not how to cover a shortfall.

HOW BANKS ASSESS A WORKING CAPITAL REQUEST → · THE CASE STUDY →