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Hope u are doing well Sir John. Can you plz help me here, I am a little stuck here! Can you please say whether my statements are correct according to overtrading. Please correct where I am wrong!
1) Overtrading is when Working capital (current asset – current liability) is too low BUT this is how identify whether the working capital has decreased from year 1 to year 2. Such as in year 1 if we have working capital of $939 BUT decrease to 919 in year 2 – Which is a SIGN of overtrading [Correct?]
2) There must be an increase in the level of inventory, receivable & payable from one year to another BUT Inventory days, Receivable days will decrease BUT Payable days will increase which is identifying that we have Current liabilities exceeds current assets [Correct?]
3) Lastly, If there is an overtrading I know that increase in short-term finance would be seen as the indicator for overtrading BUT increase in long-term finance is also seen as the overtrading indicator? [Correct?]
1. This could be a sign of overtrading, but only if other factors (such as a rapid growth in turnover) were also apparent.
All companies want to reduce their working capital by managing it more efficiently, and achieving this deliberately would not be a sign of over trading.2. I don’t really understand what you have written. The levels of inventory etc. can change for all sorts of reasons and the fact that they may have increased or decreased does not necessarily have anything to do with overtrading.
3. Again, these could be indications of overtrading, but not on their own – only if combined with other indicators.
Have you watched my lectures on overtrading?
1) Sir in overtrading past exam question called Wobnig Co (June 2012). The examiner has calculated the increase or decrease in the Levels of inventory, Receivables & Payables which he then compared & explained that there is a link of these ratios with the Inventory days, receivables days & payables days to show whether the company is overtrading or not because it will indicate the rapid increase in current assets over its liabilities (which is also another indicator for overtrading).
2) I’m a little confuse here that in overtrading questions whether we should compare the company’s indicators with several years of the company itself or with the Sector Average [if its data is given]?
1. As I wrote before, the levels of inventory etc. may be indicators of over-trading, but not on their own – there are lots of perfectly good reasons why the levels may have changed. The most important indicators are rapid growth in turnover and the increased bank overdraft. It is these two that suggest over-trading, and the changes in inventories etc. help to confirm that this is likely to be the case.
2. Both :-). Comparing with previous years is needed to see whether there is a rapid growth in turnover and whether there appear to be liquidity problems. Comparing the working capital measures with the sector averages gives an indication of whether the levels of working capital are reasonable for the type of company, whereas comparing them with previous years gives an indication of whether working capital is being managed better or not.
I ask again, have you watched my free lectures on overtrading and on the management of working capital?
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