Overtrading is the reason so many companies are going bust, says Peter Vinden, managing director of the Vinden Partnership.
In the past month contractors and subcontractors with a combined annual turnover of £750m have gone bust. Given that I penned an article called “Recovery and The Overtrading Dilemma” a year ago, it seems my tea leaf reading was up to scratch and my prediction of unwanted insolvencies is coming to pass.
So why are so many companies failing now when prices are rising and economic recovery is well underway? I am pretty sure that overtrading is the cause.
Historical data shows that the same number of firms go bust coming out of recession as those that fail in the depths of a slowdown. The reasons for this are varied, but the usual cause is losing control of your working capital requirements.
Companies need working capital to fund day-to-day trading activities. As workload and turnover increase, so too does the need for working capital to pay your trading bills, salaries and other operating expenses.
Insolvency is defined as either having liabilities in excess of assets – that is, negative net worth – and/or having no ability to pay creditors as and when payments fall due. It is the latter definition that usually causes failure and is often a symptom of overtrading.
So what are the warning signs of overtrading? The following are typical symptoms:
- Your overdraft is increasing month by month;
- Operating margins are starting to slide;
- Debtor days are starting to move out;
- Key suppliers are beginning to get nervous and apply pressure by threatening to put you on stop;
- Your accounts team begins to spend more and more time fending off suppliers and subcontractors chasing payments.
We all like to see a healthy order book and growing business and it can be very hard to turn down an offer of what you believe will be profitable work. But sometimes this is exactly what a prudent business owner should do if it is determined in advance that the project cannot be funded.
How do you avoid overtrading and certain failure? The answer is easier to say than it is to do in practice and can be summed up as cash flow analysis, projection and control.
“We all like to see a healthy order book and growing business and it can be very hard to turn down an offer of what you believe will be profitable work. But sometimes this is exactly what a prudent business owner should do if it is determined in advance that the project cannot be funded.”
It is absolutely essential that you understand the cash inflow and outflow on every project you are working on as well as the outflow of cash required to fund your operating overheads such as rent, rates, heating, lighting, administrative salaries, insurances, vehicle costs and so on. From this information you should be able to produce a company model, which shows on a week-by-week basis what your income and expenditure looks like and, in doing so, project and control what working capital is required by way of bank overdraft, loans or similar.
Each new contract win should be analysed on the same basis and imposed on your operating model and then analysed and fed into the company model before it is accepted.
It might be that you can only accept the latest contract if advantageous payment terms can be negotiated from your client or with key suppliers and subcontractors. It may be it cannot be funded at all, but the point is you need to know.
It should never be assumed that your bank will provide an increase in facilities to overcome shortfall in working capital requirements. It is precisely this sort of assumption that has led to many a company’s undoing.
So, in summary, if the decision to take on a new contract is going to increase your working capital requirement, it is essential that you understand what the increased requirement will be long before you become committed and pass the point of no return.
Lack of analysis, projection and cash modelling is likely to cause a disaster. The past month of construction company failures demonstrates my point exactly.
There is no excuse for failing to understand your business and its cash requirements. If the skill sets are not readily available in your business you simply cannot afford not to buy in these resources.
Crossing your fingers and hoping for the best, whatever that might be, is not the way to avoid overtrading and inevitable disaster. If you are a company director, have doubts about your trading position and wish to avoid being held personally liable for your company’s debts, take confidential advice before it is too late.
If only I was as successful at predicting the lottery numbers…
