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In a question called GORWA CO inventory days, receivable days & payable days where all of them have increased which is a sign of overtrading? Am I right?
Can you please explain according to ratio analysis which are signs of overcapitalization & overtrading?
No ratios definitely indicate overtrading – they can change for many reasons. Exam questions expect a discussion about the results.
It is a combination of several things that indicate overtrading – the most important being a rapid increase in turnover.
Increases in receivables days can be a sign of overtrading because the department collecting the receivables may not be able to cope with the increased level of sales.
Increases in payables days might be a sign of overtrading because they are having to delay payment due to running short of cash.
Overtrading more normally results in a decrease in inventory days although the examiner does suggest a possible explanation for the increase here.
Other important indicators are the current and acid-test ratios, and an increase in an overdraft.
This (and overcapitalisation) is all explained in my free lectures on the management of working capital.
Sir, can you please state all the ratios that are going to be used for the analysis between overcapitalization n overtrading with the relevant increase & decrease in the respective ratios that either indicates overcapitalization n overtrading.
It is difficult for me to grasp the idea of whether the relevant ratios such as inventory days n receivable days n payable days n Current assets n Current liabilities with the other ratios will increase or decrease? Can you please be specific on how to think about the ratios in term of overcapitalization or overtrading
I have seen your lecture more than once but I couldn’t understand the relevance.
I can’t, because it all depends on the information given. In the case of Gorwa you were certainly not expected to calculate all the ratios that appear in the examiners answer, only the key ones that are discussed in the discussion part. Part (b) is mainly testing your understanding of overtrading which is why half the marks are for the discussion.
The main things to look for always are the growth in the revenue – rapid growth is always an obvious sign of there being the possibility of there being overtrading; an increasing overdraft; and a reducing current ratio.
As far as overcapitalisation is concerned, this is where the level of working capital is too high for the type of business. Again, depending on the information given you could look at the ratio of the working capital to the non-current assets – if it is high then it could suggest they are overcapitalised. However again, the marks are more for discussion than simply listing lots of ratios.
In both circumstances any ratios are only really meaningful when comparing with previous years or with other similar companies.
Do remember that always at least 50% of the marks in Paper FM will be for discussion rather than for calculations. The examiner is always testing your understanding rather than that you have simply learned ‘rules’.
Overtrading causes turnover, receivable, inventory & payable days to increase while reducing the current ratio & working capital ratio.
What do you mean by ‘ratio of the working capital to the non-current assets’ in your last response? Is that the working capital ratio (Current Assets / Current liabilities)?
But overcapitalization may be indicated by the ratio of working capital which can be calculated as 1.27 in 20X3 & 1.15 in 20X4 in Gorwa Co question which indicates that working capital has decreased therefore it cannot be overcapitalization. Is that correct?
While in overcapitalization the turnover, payable days, overdraft are decreased but receivable, inventory, current ratio & working capital ratio are increased, Is that correct?
Thanks for your answer, it was helpful 🙂
No. The ratio of working capital to non-current assets is not the current ratio!!
You would expect that as a company expands then the working capital will increase more or less at the same rate as the non-current assets. If they invest twice as much in machines they will be expecting twice as many sales and will therefore end up with twice as many receivables etc..
If the working capital ended up three times as high, then it would suggest that they had too much money tied up in working capital which would suggest that they were over-capitalised.
Again, it is not a standard ratio, but as part of a discussion (which is where this would be relevant) it could be a useful indicator – comparing that ratio with either previous years or with similar companies.
In Overcapitalization, it is when the company has too much WORKING CAPITAL & where receiveable, inventory, cash will increase & so does its current assets n Non-current assets but payables, overdraft will decrease & so does current liabilities indicating increase in working capital cycle whereas it reduces NET WORKING CAPITAL.
Current ratio n Quick ratio both will increase while Interest & gearing of the company will reduce since the company has high WORKING CAPITAL to pay its liabilities.
In Overcapitalization, sales turnover will decrease with the profit margin
Is there any main financial ratio that can indicate whether the company is overcapitalization or overtrading?
Please let me know. Is that all alright?
What you have written is fine.
However as I have written before, there is no standard list of ratios you can produce to definitely be able to say that they are overtrading or that they are over-capitalised.
Any questions in the exam are testing that you understand what the two are, that you can discuss them, and that you can take whatever information is provided in the question to back up your discussion.
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