Chapter 3.2.1 Risk Of Overtrading

Question 1

Definition

Answer 1

A situation where a business has inadequate cash to support its level of sales
Also known as “undercapitalism”

Question 2

Symptoms

Answer 2

• Rapid increase in sales revenue, often falls in profit margin as discounts are used to chase higher sales
• Rapid increase in receivables and inventory, too much cash tied up. High receivables to offer credit to customer = higher sales, higher inventory to support higher sales
• Rapid increase in trade payables & rising in bank overdraft indicate liquidity problems
• Worsening liquidity ratio, cause significant increase in operating cycle

Question 3

Managing the risk of overtrading/undercapitalism

Answer 3

• Plan the introduction of new long-term capital
• Improve working capital management
• Reduce business activity

Question 4

Over-capitalisation

Answer 4

An excessive level of WC, leading to inefficiency