After reading this article you will learn about Over-Trading:- 1. Meaning of Over-Trading 2. Causes of Over-Trading 3. Signs 4. Consequences 5. Remedies.
- Meaning of Over-Trading
- Causes of Over-Trading
- Signs of Over-Trading
- Consequences of Over-Trading
- Remedies for Over-Trading
1. Meaning of Over-Trading:
In simple words, over-trading means, “a situation where a company does more business than what its finances allow. It is related to the cash position of the enterprise, and it occurs when the company expands its scale of operations with insufficient cash resources”.
The result is disastrous as over-trading gives rise to increase in size, diminishing margin of safety and feeling a sense of stress and strain. Thus, it is advisable for every company to carry on its business in terms of the financial resources it has at its command and not to do more business or excessive trading than what its finance permit.
2. Causes of Over-Trading:
i. Inflation and Rising Prices:
Over- trading takes place as a result of an inflationary situation and high prices. Business dealings become costly, machinery and raw materials become expensive and the company has to spend excessively in costs to maintain its level and standard of efficiency. Such a situation results in overspending by the company, which we call over-trading.
ii. High Incidence of Taxation:
We usually find companies and business undertakings being heavily taxed. As a result of excessive taxation, the companies cannot give a good return to its investors. Moreover, the margin of profits after tax is so less that it becomes impossible for the company to maintain itself. Thus, it has to spend out of its own pocket and indulge on over-trading.
iii. Increased Lock-up of Funds in Stocks:
Over-trading also takes place as a result of increased lockup of funds in the form of stocks by the company. Such a situation arises when supplies of materials are erratic, and the company has to keep high stocks in order to keep the production going. Thus, keeping huge stocks as a precautionary step involves the tie up of company’s funds and as a result, over-trading takes place.
Over-expansion, i.e., increasing the pace of production and development in a company, especially after a period of war or depression, results in over-trading. The owners at this stage are more interested in the development activities and as a result, they ignore financial background, often spending more than what their funds permit.
3. Signs of Over-Trading:
i. Increase in bank borrowings and loans.
ii. Increase in stocks.
iii. Purchase of fixed assets out of short-term funds.
iv. Decline in the working capital ratio, i.e Working Capital/Sales or Working Capital/Production
v. Decline in the rate of gross and net profits.
vi. Low current ratio and very high turnover ratio.
4. Consequences of Over-Trading:
i. Inability of the management to pay wages to the employees and taxes to the government.
ii. Decline in sales and costly purchases.
iii. Difficulty in raising funds because of poor creditworthiness.
iv. Problems with debtors and creditors.
v. Inability of the management to carry out timely repairs and maintenance resulting in inefficient working.
vi. Lack of funds will compel the company to go in for out-dated and old machinery for replacement purpose.
5. Remedies for Over-Trading:
i. The company should cut down its business and over-spending or it should arrange for more funds.
ii. Preventing a situation of over-trading by taking precautionary steps.