What are the mitigation measures available to a bank to prevent (i) over-trading and (ii) diversion risk? Begin by explaining what over-trading and diversion risk mean……………………………………………….(10)
Introduction
Overtrading is a situation that occurs when a business grows too rapidly without enough long-term sources of finance to meet its over-increasing working capital requirements. Both previous and current financial statements need to be analysed, for one to come up with a conclusion that an organisation is overtrading. Making conclusions at glance will lead to wrong conclusions. Signs in the financial statements which highlight that an organization is overtrading include the following:
- An increase in growth accompanied by falling profit margins – a double increase in the sales of the organisation, with a significant decline in the profit margins, can be an indication of overtrading. However, other factors may have caused this occurrence, high sales may have been caused by generous credit terms, with huge discounts which cause a decline in profitability. The low selling price may be the cause, which reduces the contribution.
- Decline in the net profit margin – huge decline in the profit margin may be another indicator of overtrading, however, we said indicators of overtrading cannot be analysed in isolation. Other causes of declining net profit margins include an increase in wages, bonuses, high depreciation charges on new machinery if the company is using a reducing balance method, or high interest or tax payment in that particular year.
- Increase in sales not accompanied by an increase in debtors –
- Depletion of cash reserve from the previous year – depletion of cash reserves can be another indicator of overtrading. However, better care needs to be taken and see if the depletion has not occurred as a result of the repayment of long-term or short-term debts.
- Increase in the creditors – this is another indicator of overtrading, especially indicated by an increase in the level of overdraft. A good example occurs when the organization did not have an overdraft in the previous year and now has an overdraft this year, which is supported by the declining cash reserves of the firm. A good analysis will compare both current and previous years’ cash and bank balances.
- Funding capital expenditure with short-term sources of finance – funding long-term capital expenditure with short-term sources of finance may be another indicator of overtrading. The concluding remark here is that the organization may have exhausted its lines of long-term credit and now resort to short-term sources of finance.
- Falling of the current ratio and quick ratios – this is the indication of a firm’s ability to meet its short-term liabilities. Worsening of the two ratios may be a very good indication of overtrading in the organization.
- No sign of an increase in equity – this can be another sign that the organization is overtrading. If the firm is issuing new equity as a source of long-term source of finance, it may be overtrading especially when the firm has engaged in capital expenditure in the financial period in question.
Ways of reducing the problem of overtrading
There are various ways available at a firm’s disposal in the process of reducing or curbing the problem of overtrading. The ways that are available include the following.
- Issue of new equity – the issue of new equity can be another way of loosening the liquidity of the firm, despite the fact that it comes with a dilution of control of ownership. The proceeds from the issue can be used to find long-term capital expenditure or reduce the debt component of the firm.
- Taking long-term debt – long-term debt is not paid on demand, thus offering an advantage compared to the use of overdraft.
- Debt factoring – improves the cash position of the organization through the selling debtors’ list to a factoring company.
- Increasing the payables payment period – delaying payments to trade creditors, which however needs to be managed because excessive delays will lead to restrictions on further credit in the future.
- Improving the debt collection period – rigorous debt collection methods need to be adopted, to ensure that the company’s debtors pay in time and avoid bad debts. Discounts may be used for early payments, encouraging clients to settle their accounts in time.
Checking the liquidity ratio – the company should continuously check its liquidity position through the use of current and quick ratios, these ratios will act as signals for an imminent decline in the liquidity position and call for remedial action.