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Sir, you said in the lecture on overtrading that if the company is expanding & intends to double in size over the next year that means receivables, inventory & payables will also double in size and due to liquidity problems we will be forced to take the overdraft.
1) Then is it true that if sales are increasing 40% from one year to another; receivables, inventory & payables should also increase by 40% if the company is expanding?
2) When you said overcapitalization means working capital too high which can simply be an indicator (i guess) to identify whether the company is overcapitalizing or not by simply looking at levels of receivables, inventory & payables from one year to another.
And in case with overtrading if the level of working capital is too low which means receivables, inventory & payables are too low.
How would we deal with the indicators in the exam that company is overtrading or not? Can you please help me that how do you think which is causing overtrading?
What I actually say in my lecture is that if the company were to double in size then they should expect to have twice as high inventory, receivables and payables and so they should have planned ahead and raised more long-term capital. Overtrading is where this happens rapidly and where they haven’t raised more long-term capital and therefore are financing out of short term borrowing leading to liquidity problems.
So for (1) – yes, they would expect them to also increase by 40%.
Overcapitalisation is completely separate and where the company has allowed receivables etc. to be higher than they reasonably should be for the type of business (preferable by comparing with similar companies).
Overtrading does not mean that receivables etc are too low.
There is no specific list of indicators for over-trading. The most immediate signs are rapid growth in the revenue, an increase in short-term finance, without an increase in long-term finance.
Best is to look at questions on this in your Revision Kit and check what is discussed in the answer (again depending on the information available in the question).
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