Definition of Overtrading:
Overtrading occurs when a business expands its sales and operations beyond the capacity of its current financial resources. This typically results in insufficient working capital to support the increased level of business, leading to liquidity problems despite appearing profitable on paper.

Symptoms of Overtrading: Financial backers of tenanted-pub firms might notice the following symptoms of overtrading:

• Declining Liquidity Ratios: The increased investment in current assets needed to support the expanded sales is financed mainly by short-term sources like creditors and bank overdrafts, leading to declining current and quick ratios.
• High Sales-to-Equity Ratio: Sales increase rapidly in relation to equity, causing a sharp rise in the ratio of sales to equity.
• Increased Gearing: The firm takes on more debt, leading to higher gearing ratios, which indicate a greater reliance on borrowed funds.
• Negative or Declining Net Working Capital: The net working capital may decline or even become negative, which means that current liabilities exceed current assets, creating potential liquidity crises.

Possible Causes of Overtrading Symptoms:

• Rapid Expansion: The firm may have expanded its operations too quickly without securing adequate long-term funding.
• High Inflation: In periods of high inflation, sales turnover and working capital requirements can increase sharply in nominal terms, creating the appearance of overtrading.
• Loan Repayment Pressures: Repaying loans without raising sufficient long-term funds can drain cash, exacerbating liquidity problems.
• Excessive Dividend Payouts: High dividend payouts may deplete equity, worsening the firm’s liquidity position.
• Misallocation of Funds: Using short-term funds to finance long-term investments can lead to symptoms similar to overtrading.

Overcoming Overtrading:

• Improve Working Capital Management: Firms should focus on better inventory control, credit policy, and debt collection to reduce the investment in current assets required to support sales.
• Secure Long-term Financing: The firm should arrange for long-term sources of funds to finance the working capital needs, thus improving the net working capital position.
• Restrict Sales Growth: Limiting the growth in turnover to manageable levels can prevent the firm from stretching its financial resources too thin.
• Careful Financial Planning: Financial planning should include considerations for maintaining adequate liquidity to support expansion.

(8 marks)