Why exponential growth isn't such a good thing

Why did a company that seemed to be booming, raking in cash on paper, get refused cover when one of our clients was weighing up entering a supplier relationship with them? Despite growing turnover by 70% in one year, 15 months later the company in question went bust. Credit Risk Analyst Roberto Simone examines why.

What is overtrading?  

When growth controls the business, rather than the business controlling growth, there may be trouble ahead. 

Overtrading is  where a business enters into commitments beyond its available short term resources. Typically, trying to make a profit with too little working capital underpinning the effort. Overtrading can be difficult to spot as it’s caused by time lags within the business model, not easily discernible to outsiders.  

A lot of companies overstretch resources in hot pursuit of ambitious expansion targets. That can mean something seemingly simple, like taking on a large contract within a known supply chain, or more obviously resource-intensive moves, like R&D or expanding into other markets internationally. 

A company might not be aware they’re overtrading. 

Almost as often as companies expand for the right reasons, they might be expanding in an attempt to play their way out of some underlying financial trouble. 

If you play poker, you’ll recognise the concept of going ‘on tilt.’

Companies can go on tilt, too. 

The overtrading cycle: how companies go “on tilt”

 
1. Plan

Planning is paramount in business. If you don’t get the first chapter right, their probably won’t be an autobiography any time soon. 

An example of a business doing planning well: 

Companies trading sustainably strike a balance: they plan, but not in a hesitant way that sacrifices velocity. 
For example, one of our clients spent two years sending representatives to a new country they were considering moving into – they learned every nuance of that region that they could before fully committing. 
That’s proactive, but sensible. 

How an overtrading business does planning:

Fast, reactive, on the hoof, on a whim or a hunch. Aggressively, wearing their cognitive biases on their sleeve and seeking only information that supports what they have subconsciously decided.  

Sometimes a business doesn’t even realise how short of knowledge or business intelligence it is. 

It’s not uncommon for companies exporting to only find out about certain tariffs and legislation that proves severely detrimental to the bottom line once it’s far too late to renege on the deal. 

Poor planners should expect poorer margins – and poorer futures.   

2. Expand  

Proactive or reactive, expansion needs to happen with a safety first mentality. 

How a sustainable business expands:

Creep and peep, like driving a car out of a busy junction with poor visibility. Making sure you get a clear picture before committing to a move. Essentially, to their own plan, at their own pace. Proactively seeking new business opportunities, but always working within their means. 

Going beyond the simplest, just doing more of the same in existing supply chains, three of the most common expansion methods are:

1. Moving into new regions, either nationally or internationally 
2. Diversifying into new products, services or sectors
3. R&D trying to innovate and create something ground-breaking, either within the existing sector or with some element of diversification attached 

All of them come with inherent risk, and the more there is going on simultaneously, the more pressure on financial, intellectual capital and management energy levels.  

How an overtrading business expands:

Attempt too much at once and the risk stacks up like Jenga…classic overtrading.  

Going for too much at once, diving in without proper research or analysis can lead to unforeseen factors eating into profit margins. For example, Company A planned to manufacture and export some merchandise. Just when it’s too late, they were horrified to find out about an import tariff applied to the goods. Little details can make the final retail price prohibitively expensive – even worse, when you’ve brought raw materials to make many more than they’ll ever shift.  
This can cause knock on effects throughout the supply chain, all for the want of thorough planning. 

3. Expend     

Put simply, all expansion costs money and time. The source of the funding - and at what the cost of capital - is the difference between doing things right or growing before you’re ready. 

How a sustainable business expands: 

All expansion costs time and money; a success factor is doing it a cost effectively as possible. That means using low cost capital.  

Taking on extra headcount to help manage the influx of work is all well and good. Companies growing sustainably take their time hiring, get the right people and work hard to imbed them into the company culture.   
As my colleague Mark Fosh says, it takes six months before a new member of staff starts adding maximum value. 

How an overtrading business expands:

Growing quickly usually means taking on more people – companies growing exponentially are often forced to bring in multiple people in key positions thrown into the deep end all at once. 

Rapid growth often means taking on more debt. 

Regularly borrowing money, especially short term, is a hint that a company might be in the cycle of overtrading; if they’re borrowing money to take on staff, that almost confirms it.   

It’s a classic robbing Peter-to-pay-Paul scenario: loaning money to take on staff is buying time with money you don’t have (and paying a premium to the bank for the privilege). 

If a company hasn’t got the cash reserves in place to fund any initiative, but they go for it anyway, the underlying fundamentals don’t look quite right (and presents a risky trade to potential partners).  

4. Credit Control 

The financial heartbeat of a business is the approach to credit control. 

How sustainable businesses do credit control:

A diversified client base on generous, yet sensible credit terms. Structured internal processes with a level of digital automation. A sales ledger secured as an asset through credit insurance - and also not afraid to mix it up with a tenacious, even belligerent, debt collection mode when needs be.   

It takes a balanced customer base to be successful: ideally everyone would pay on time, but that’s rarely reality. 

How overtrading companies do credit control:

Control is the operative word. Overtrading companies are losing their grip. 

Revenues naturally take longer to filter back through certain channels than others. 

Depending on the nature of the expansion, it can take a long time to see return on the expenditure above – and profit margins can often be thinner. 

A classic overtrading move is putting the chance to enhance the reputation ahead of the potential effects on profitability. For example, dealing with a big brand company that will look great to have on the books but letting them negotiate down too far on key financial aspects of the deal: price, margin, deposits, payment terms etc. etc.

This can be seriously detrimental to cashflow. 

Some clients negotiate really long credit terms and are routinely late paying even then. Some will even enter into disputes around quality or service, to stretch things out, ease their cashflow, possibly to cover their own overtrading. 

If you’re spending to do work that it takes ages to get paid, that’s overtrading – if you seek to fill the gaps by winning some new business that pays faster – that’s over-over trading. 
And so the black hole deepens…

5. Unexpected events: good, bad and ugly

Unexpected events, good and bad, are huge behavioural drivers for businesses. 

When you’re growing quickly and have the opportunity to expand your business, it makes sense to ride the wave and capture the opportunity – and when you’re afraid of a downturn, you take whatever is going.  

The Good

An example of a good event would be receiving an inbound offer of a contract or a request-for- proposal out of the blue. 

The Bad

A worse one would be delays in your supply chain, and the knock on effects meaning late fulfilment of orders, hence a longer timeframe between your initial expenditure and the money flowing back into your business.

The Ugly 

A much worse one would be cataclysmic macro event, for example a recession.
…and then back to Step 1 but under pressure

Unforeseen events all have different effects but they all lead to one place – back to Step 1 of the cycle, right back to the beginning of the loop, the planning stage – only now in a rush, under pressure and potentially in a stressful situation. Being stressed makes decision-making more cavalier, so it’s easy to see why businesses can see a series of shocks come their way.   

The cycle turns: faster in some ways, slower in others – spend quicker, reap rewards slower, and thus the financial seams start to come undone. 

Symptoms of overtrading: how to spot it

Frequent Symptoms of Overtrading

• Slower paying with lengthening Days-Payable-Outstanding (DPO)  
• Rapid growth in turnover that’s not scalable…and not relative to assets.
• Increase in the gearing ratio    
• A decline in the liquidity expressed in lower current and quick ratios.
• Reduction in the proportion of assets financed by funds from shareholders
• High level of debt servicing costs
• Inaccurate or unrealistic cash budget with poor cashflow
• Slow movement of stock and therefore cash tied up
• Having many unpaid vendor
• Decline in profitability 

Any company can make money in the good times. It’s the great ones that make money in the bad times.

With the ideal conditions, product offering and business strategy exponential growth and trading over and above means can be positive. It can enhance the brand and provide even further opportunity down the line, and make jobs along the way. 

Borrowing in order to fund growth isn’t always a damaging thing but the rate at which you grow, spread risk and forecast are extremely important. A tough period with lost business, delayed payment can trigger a series of events leading to protracted default or at worse insolvency. 

Even a little shock, or more likely, a series of small shocks, can derail the whole business. 

If there are ambitions or an opportunity for instant growth (and it does happen) it’s important to take a conservative approach. Think stability. 

As I always say, any company can make money in the good times. It’s the great ones that make money in the bad times. 

And one thing they have in common: they’ve built on solid financial foundations. 
Solidify your financial foundations with credit insurance 

It’s hard to spot overtrading, and whether you trade with an over trader is not always black and white. 

If you have credit insurance you are doubly prepared. 

About Howden Strategic Trade Credit Strategic Division

Howden Strategic Trade Credit provides tailored services to help you manage your business risk. Enhanced market intelligence and economic insight helps you make informed decisions around business development and employ better use of resources.