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How to avoid the dangers of overtrading amid recovery

What problems are posed by overtrading for small businesses and what are the warning signs to look out for?

It is almost always the case that in times of economic duress, smaller businesses can expect to take a harder hit than their larger counterparts.

What might not be common knowledge is that the recovery period following a recession can be even more challenging, with the spike in business enquiries bringing its own dangers for construction SMEs.

This means the battle is far from over for the resilient SMEs that have managed to survive recession and crumbling construction figures. 

Research shows that, despite the numerous obstacles many businesses had to overcome during the downturn, many companies go bust during the recovery as a result of overtrading.

Overtrading conundrum

The overtrading dilemma is created when a rejuvenated industry brings contract offers that exceed a company’s working capital availability.

“Maintaining ‘cashflow analysis, projection and control’ systems, or understanding the cash inflow and outflow on each of your firm’s projects, can prevent overtrading”

This is a particular problem now that the construction sector is reporting soaring figures, as it presents the temptation for still-fragile SMEs to take on more work than they are able to finance.

We all like to see a healthy order book, but taking on as many available contracts as possible is simply not a good idea.

Companies need working capital to fund day-to-day activities and, as workload and turnover increases, so too does the need for working capital to pay your trading bills, salaries and other expenses.

Catastrophic consequences

Although the overtrading phenomenon affects companies of all sizes, succumbing to the prospect of an extra contract is especially catastrophic for SMEs.

When overtrading takes hold of a business, working capital is simply used up before client payments are due in, resulting in an inability to pay creditors when payments to them fall due.

This position is the definition of insolvency, which invariably will spell the end for most SMEs if it is not identified and corrective action not taken.

This is why it is essential smaller businesses remain diligent when identifying what appears to be higher-margin work that in reality cannot be funded.

Maintaining cashflow analysis, projection and control systems, or understanding the cash inflow and outflow on each of your firm’s projects, can prevent overtrading. 

How to avoid overtrading

There is no reason for any business, large or small, to have an inadequate understanding of the way its operations work.

Swerving the post-recovery problem of overtrading requires a thorough understanding of the outflow of cash required to fund operating overheads such as rent, rates, heating, lighting, administrative salaries, insurances, vehicle costs and so on.

“By maintaining good systems of cash analysis and control, you will ensure your future successes and avoid the overtrading crisis that is ready to sink the unwary”

From this information you should be able to put together a coherent company model that reflects what your income and expenditure looks like, week on week.

By using this model, a business can project and control what working capital is required through bank overdrafts, loans or similar.

Each new contract award needs to be analysed on the same basis and merged with your operating model, while any potential contract needs to be examined and integrated with the company model before you accept the job.

This process will highlight which contracts can and cannot be accepted, which could bring some disappointing results.

Worth the disappointments

However, the initial dismay experienced when turning down a job offer is nothing compared to facing insolvency right at the very time when business was looking up.

With growth in the construction sector projected to increase over the coming years, there is plenty for businesses to be excited about.

However, history serves as a valuable lesson for how quickly success can turn to failure, and it takes patience and care to stop easy errors becoming debilitating mistakes.

This is why any SME with ambitious long-term goals should guard against the risks of overtrading.

By maintaining good systems of cash analysis and control you will ensure your future successes and avoid the overtrading crisis that is ready to sink the unwary.

Peter Vinden is managing director of The Vinden Partnership

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