Overtrading: The Hidden Danger of Rapid Business Growth

:: 00:00

Most business owners, including myself, aspire to growth. But did you know that growth specifically rapid growth, can be a very, very dangerous thing? In this week's podcast, I'm going to be diving into this crucial topic of growth. Specifically how rapid growth can lead to a hidden danger called overtrading. It’s a trap that even businesses that are profitable can fall into with the disastrous consequences that follow.

:: 00:29

A scene. Imagine you're building your business, your emotion, your drive, your passion. You're pouring your heart and soul into it, and growth is that ultimate goal, that ultimate aspiration, right? After all, if your business isn't growing, it's probably going backwards. It's falling behind, but there's a twist in the tale.

:: 00:47

Uncontrolled and rapid growth can wreck even the most promising ventures. Now, this brings us nearer to this topic of overtrading. What actually is it? In simple terms, it's when your business takes on more than it can handle both in financial and operational terms or a combination of the two. Imagine revving your car engine so hard that it blows up.

:: 01:10

That's similar to overtrading. Now to explain this, let me share a story. I'm going to introduce Serena. Now, Serena, let's say four years ago, she started a boutique business making high quality bags. Things are steady, turning over 250,000 pounds a year with a 30,000 pound profit margin. She has an overdraft facility of 20,000, just in case those unexpected bills come in just in case demand is low, but those bills are still going to be paid.

:: 01:38

Those overhead and running costs are still got to be met. And then one day that dream deal comes along. A big major retailer puts in an order for 50,000 pounds worth of her bags every month for the next two years. That's got to be exciting, right? It's the kind of moment that many business owners and entrepreneurs dream about.

:: 01:58

Let's see what happen next. Now, to meet the demand, Serena orders more materials, takes on more staff, and ramps up the production line. By month two, the first batch has been delivered. But there's a catch. Her payment terms with a retailer are an eye watering 70 days, and that's over two months before Serena will see any of that money in her bank account.

:: 02:21

Meanwhile, her suppliers want to be paid sooner. They've got their own bills to pay. They don't want to extend their credit terms, so Serena goes to the bank and asks to increase her overdraft limit. They agree initially. But by month three, thecracks are forming. Suppliers aren't being paid on time. That cash isn't coming in.

:: 02:42

They're stopping deliveries now of the materials required to make those bags. Legal threats are piling up and the bank getting a bit jittery, a bit nervous refuse to extend the overdraft. Serena's business is now in serious trouble. This everybody is overtrading. In action, it’s what happens when growth outpaces cash flow.

:: 03:04

Now, there are trigger signs. There are warning signs. These include: cash flow struggles. Materials are being purchased, staff are being paid. You want to keep the lights on, but the revenue, the cash flow isn't coming in fast enough to meet that cash outflow. Secondly, you are overinvesting in resources. You need to buy more equipment.

:: 03:25

You need to stock up with more inventory. You need additional staff. Otherwise, you're not going to be able to operate and those reserves are going to quickly diminish. There are going to be tensions with your suppliers. Those suppliers you haven't been paid will understandably want to be paid, and they will, if needed, stop working with you.

:: 03:43

Worst case, they will take legal action against you and you're going to have that legal scimiter hanging over. Other signs, there are going to be banking roadblocks. Lenders understandably will be hesitant to extend credit when they see some instability. And if they do advance credit facilities, then likely it’ll be more expensive 'cause they perceive the risk as much greater.

:: 04:04

But also your profit margins will take a squeeze. In order to fulfil those orders, those retailers by the way, are going to be negotiating strong and hard. Discounts, increased costs to fulfil those large orders will gobble away at your profits. Now overtrading isn't just a theoretical issue. It's a very common pitfall, especially for startups and those businesses that suddenly experience rapid growth. Growth demands investment, not just in cash investment, but also staffing resources to meet it as well.

:: 04:34

Too much, too fast, and you create a cash crunch. Now, having said that. How can we actually avoid it? Now, there are a few strategies that Serena could have adopted. Firstly, negotiating her payment terms. If she'd secured shorter terms, say 30 days, instead of the 70 days, the cash flow would've been more manageable.

:: 04:53

She might be thinking, I can't go down that route of negotiating 70 days, otherwise I won't get the business. Well, you need to be strong and firm and make the case. Secondly, exploring the different options for financing. Tools like invoice financing or factoring can convert those unpaid debts into immediate cash.

:: 05:13

Instead of buying equipment outright, perhaps the equipment could have been hired or leased. That working capital, that central ATM of the business would've been kept intact. Thirdly, managing those supplier relationships carefully. By communicating with our suppliers, perhaps even asking them if it were possible to extend the credit terms, making those payments on time would've kept them on site during those busy periods.

:: 05:36

There are two more bits that she could have factored in. Investing in a back office support, the infrastructure, making sure she's got enough resources, for example, in the accounts team, having good strong credit control chasing the payments and keeping track and cash flow will be a lifesaver. A more critical thing would've been to actually have done a cash flow forecast,

:: 05:56

a cash plan. Having that idea of what the future looks like in cash flow terms makes the anxiety much less, and it makes it easier to take account of what lies ahead. Now there's a key takeaway here. Growth isn't just about winning new contracts - adrenaline rush though it may be. It's about sustaining that growth and you need to track two critical numbers.

:: 06:17

Number one, cash flow, the money coming in and out of your bank account on a daily basis. There's a truism in business that you can sustain and survive without making profits, but once you run out of cash or access to it, close the lights as you leave the building. You will not survive. The second thing to track is the working capital, and that's the flow of inventory, supplier payments, and cash.

:: 06:40

And these are the resources available to cover the short term obligations, like paying your staff, paying suppliers, paying the bills, and paying yourself. If any of these run dry, even most profitable business will collapse. As we draw things to a conclusion, remember this: growth is a positive thing. It's the goal for most of us.

:: 06:58

And even if your ambition to grow is not significant, remember, standing still means you're going backwards, but growth has to be managed carefully. Take the time to plan your cash flow, do those forecasts, access and secure flexible funding options, and negotiate terms that keep the balance in your favour.

:: 07:16

This is not a one directional conversation, and if you're considering taking a major leap, ask yourself, do I have the resources and the systems in place to handle it? If the answer is no, it might be wiser to hold off, scale up more gradually or make that investment. If this episode resonated with you, well check out the show notes for links to more resources.

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Until next time, stay savvy.