Overtrading vs. Overcapitalization – What is this about?

Last week we touched on the topic of working capital. We defined working capital as a financial metric that is calculated by obtaining the difference between the total of current assets subtracted the total of current liabilities.

Read more: What is Working Capital and How can I Manage it?

Also, the importance that this metric has in determining liquidity and available capital was discussed too.

Considering that It is an important metric for companies to know and improve, today we are going to discuss how to better manage working capital.

What do I need to know about Working Capital?

To be able to improve how working capital is being managed it is important that we understand the relevant factors involved.

For example, when we talk about current assets remember that essentially, we are looking at cash, bank accounts and inventory, while on the other side of the Balance Sheet for current liabilities its accounts payables.

Therefore, the factors that will come into play that will have the greatest effects on working capital and how much is either available or not will be based on: inventory at hand, credit policies with customers, purchasing from vendors and accounts payables.

Overtrading vs. Overcapitalization – What is this about?

So, with those factors in mind it is important to establish criteria that will help you to better manage your working capital available.

Why is this important? Well it is important because if there is no balance between having sufficient and having too much working capital then this results in what is known as either overtrading or overcapitalization.

Overtrading is when you spread your business too thin in an effort to raise more business, which may seem ironic but is very true. Say for example, the opportunity comes to start a new contract that will long term provide considerable benefit to your company. At first glance, it may seem to be the answer to all your problems, but what about the short term? Remember a sudden increase in sales usually also means a correlative increase in costs, but will you be able to cover increased costs while providing the new service or products while you are waiting for payment?

Or what about selling at a discount to entice clients to pay you quicker? This can definitely have a positive effect on your working capital, but remember when selling at a discount you will be lowering your profit margin and also lowering inventory because offering discounts usually entices higher volume purchases, so will you be able to cover manage your business with a profit margin and inventory that has been suddenly reduced?

The opposite of this situation is overcapitalization, and this is when the company is not utilizing moving its inventory or the company is overleveraged and has too much capital that is simply doing nothing.

Even though the second situation may not seem too bad, it could still be very bad for the company depending on the circumstances.

So, the best thing to do is establish a cushion and make sure that not only is your business able to grow and adapt but also use its capital to its advantage.