Overtrading

A business "overtrades" when its requirements for additional working capital < internally generated cash.

Example:
If a company generates $1,000,000 in sales this year and its working capital requirements amount to $750,000, the business needs $0.75 of working capital to support each additional extra dollar of sales next year.

If the company retains $0.10 of each dollar from sales after tax, i.e. $100,000 in total per annum (before capital expenditures), an additional $133,333 of additional sales can be supported next year ($100,000/0.75).

If the company expands by 25% next year to £1,250,000 revenues, there will a financing gap of $54,167*, which will have to be financed from additional borrowings or new equity. A growth rate in excess of 13.3% per annum in these circumstances is "overtrading".

* $250,000*0.75 = $187,500 - $133,333 = $54,167. (Figures ignore fixed capital requirements).

If retained cash per $/Working capital per $ after fixed capital expenditures < Sales growth rate, the company is said to be overtrading (internal financing needs outstrip internally net generated funds).

There is nothing basically wrong with overtrading, providing management recognise the financing requirements involved, and providing adequate funding is available to meet additional working capital needs.

Reference Pages

Good Performance Model

Self Financing Growth

Funding Gap