Overtrading and Under Capitalization | Working Capital

In this article we will discuss about the impact of overtrading, under capitalization on working capital.

Impact of Overtrading on Working Capital:

Overtrading arises when a business expands beyond the level of funds available. Overtrade means an attempt to finance a certain volume of production and sales with inadequate working capital. If the company does not have enough funds of its own to finance stock and debtors, if it wishes to expand then it is forced to borrow from creditors and from bank in the form of overdraft.

Sooner or later such expansion, financed completely by the funds of others, will lead to a chronic imbalance in the working capital ratio. A firm should always maintain adequate working capital to support its sales activity. Overtrading is a situation where a firm attempts to increase its sales level without having a support of adequate working capital.

The overtrading situation will lead to high pressure on liquidity and the firm would feel difficult in paying creditors within the credit period allowed. This in turn would lead to difficulty in procurement of raw materials and services in time.

This will adversely effect the production process and the firm will be forced to slowdown its activity. This in turn will adversely affect the working capital position and ultimately it leads to negative profitability of the firm.

Therefore, the overtrading should be detected in time and remedial action should taken either to increase the availability of working capital to match the increased sales level or the firm should slow down its activity level to the working capital available with the firm.

Expansion is advantageous so long as the business has the funds available to finance the stocks and debtors involved. Overtrading begins at the point where the business relies on extra trade credit and increased turnover are financed by taking longer periods of credit from suppliers and/ or negotiating and extension of overdraft limits with the bank.

Overdependence on outside finance is a sign of weakness, unless the expansion is curtailed, suppliers may refuse credit beyond certain limits, and the bank may call for a reduction of the overdraft.

If this happens, the business may be insolvent in that it does not have sufficient liquid resources (cash) to pay for current operations or to repay current liabilities until customers pay for sales made on credit terms, or unless stock is sold at a loss for immediate cash payment.

Impact of Under Capitalization on Working Capital:

Under capitalization is a situation where the company does not have funds sufficient to run its normal operations smoothly. This may happen due to insufficient working capital or diversion of working capital funds to finance capital items.

If the company faces the situation of under capitalization, it will suffer from the following disadvantages:

(a) The firm will face difficulties in meeting current obligations and in meeting day to day running expenses.

(b) It is unable to procure raw materials and stores items in time.

(c) The long-term fixed assets cannot be utilized at optimum level.

(d) The return on capital employed would be lower due to lower capacity utilization.

(e) The firm will face difficulty in meeting the delivery schedules, causing loss of goodwill as well as prolonged operating cycle.

(f) The discounts on cash purchases and bulk purchases cannot be obtained by a cash starved concern.

The Finance manager should take immediate and proper steps to overcome the situation of under capitalization by making arrangement of sufficient working capital.

The measures suggested to overcome the situation of under capitalization are as follows:

(a) Prepare the realistic cashflow and funds flow statements.

(b) Retain the profits earned in the business.

(c) The fixed assets which are not contributing to return on capital employed should be disposed of to increase cash resources.

(d) Steps may be taken to raise long-term funds through issue of shares, debentures or raise long-term loans from banks and financial institutions.

(e) Increase the inventory turnover ratio.

(f) Revise and reduce the credit collection policies and procedures.

(g) Concentrate on core business activities and divest the unprofitable segments and units.

Impact of Over Capitalization on Working Capital:

If there are excessive stocks, debtors and cash, and very few creditors, there will be an over investment in current assets. The inefficiency in managing working capital will cause this excessive working capital resulting in lower return on capital employed and long-term funds will be unnecessarily tied up when they could be invested elsewhere to earn profit.

Poor Working Capital Management Symptoms:

In general, the following cases are seen in inefficient management of working capital:

(a) Excessive carriage of inventory over the normal levels required for the business will result in more balance in trade creditors accounts. More creditors balances will cause strain on the management in management of cash.

(b) Working capital problems will arise when there is a slowdown in the collection of debtors.

(c) Sometimes, capital goods will be purchased from the funds available for working capital. This will result in shortage of working capital and its impact is on operations of the company.

(d) Unplanned production schedules will cause excessive stocks of finished goods or failures in meeting despatch schedules.

(e) More funds kept in the form of cash will not generate any profit for the business.

(f) Inefficiency in using potential trade credit require more funds for financing working capital.

(g) Overtrading will cause shortage of working capital and its ultimate effect is on the operations of the company.

(h) Dependence on short-term sources for financing permanent working capital causes lesser profitability and will increase strain on the management in managing working capital.

(i) Inefficiency in cash management cause embezzlement of cash.

(j) Inability to get working capital limits will cause serious concern to the company and, sometimes, may turn-out to be sick.