OVERTRADING AND UNDERTRADINGThe concepts of overtrading and undertrading are intimately connected with the net working capable position of the business. To be more precise they are connected with the cash position of the business.OVERTRADING:Overtrading means an attempt to maintain or expand scale of operations of the business with insufficient cash resources. Normally, concerns having overtrading have a high turnover ratio and a low current ratio. In a situation like this, the company is not in a position to maintain proper stocks of materials, finished goods, etc., and has to depend on the mercy of the suppliers to supply them goods at the right time. It may also not be able to extend credit to its customers, besides making delay in payment to the creditors. Overtrading has been amply described as “over blowing the balloon”. This may, therefore, prove to be dangerous to the business since disproportionate increase in the operations of the business without adequate resources may bring its sudden collapse.Causes of overtradingThe following may be the causes of over-trading: (i) Depletion of working capital:Depletion of working capital ultimately results in depletion of cash resources. Cash resources of the company may get depleted by premature repayment of long-term loans, excessive drawings, dividend payments, purchase of fixed assets and excessive net trading losses, etc.(ii) Faulty financial policy:Faulty financial policy can result in shortage of cash and overtrading in several ways:(a)Using working capital for purchase of fixed assets.(b)Attempting to expand the volume of the business without raising the necessary resources, etc.(iii) Over-expansion:In national emergencies like war, natural calamities, etc., a firm may be required to produce goods on a larger scale. Government may pressurize the manufacturers to increase the volume of production without providing for adequate finances. Such pressure results in over-expansion of the business ignoring the elementary rules of sound finance.(iv) Inflation and rising prices:Inflation and rising prices make renewals and replacements of assets costlier. The wages and material costs also rise. The manufacturer, therefore, needs more money even to maintain the existing level of activity.(v) Excessive taxation:Heavy taxes result in depletion of cash resources at a scale higher thanwhat is justified.The cash position is further strained on account of efforts of thecompany to maintain reasonable dividend rates for their shareholders.

Consequences of overtradingThe consequences of over-trading can be summarized as follows:(i) Difficulty in paying wages and taxes:This is one of the most dangerous consequences of overtrading. Non-payments of wages in time create a feeling of uncertainty, insecurity and dissatisfaction in all ranks of the labour. Non-payments of taxes in time may result in bringing down the reputation of the company considerably in the business and government circles.(ii) Costly purchases:The company has to pay more for its purchases on account of its inability to have proper bargaining, bulk buying and selecting proper source of supplying quality materials.(iii) Reduction in sales:

The company may have to suffer in terms of sales because the pressure for cash requirements may force it to offer liberal cash discounts to debtors for prompt payments, as well as selling goods at throwaway prices.(iv)Difficulties in making payments:The shortage of cash will force the company to persuade its creditors to extend credit facilities to it. Worry, anxiety and fear will be the management’s constant companions.(v) Obsolete plant and machinery:Shortage of cash will force the company to delay even the necessary repairs and renewals. Inefficient working, unavoidable breakdowns will have an adverse effect both on volume of production and rate of profit.

Symptoms and remedies for overtradingThe situation of overtrading should be remedied at the earliest possible opportunity, i.e., as soon as its first symptoms are visible. The symptoms can be put as follows :( a) A higher increase in the amount of creditors as compared to debtors. Th is i s because o f f i rms inab i l i t y to pay i t s c red i to r s in t ime and exercising of undue pressure on debtors for payments;(b)Increased bank borrowing with corresponding increase in inventories;(c)Purchase of fixed assets out of short-term funds;(d)A fall in the working capital turnover (working capital/sales) ratio.(e)A low current ratio and high turnover ratio.The cure for overtrading is easier to prescribe but difficult to follow. The cure is simple-reduce the business or increase finance. Both are difficult. However, arrangement of more finance is better. If this is not possible, the only advisable course left will be to sell the business as a going concern.

UNDERTRADING:It is the reverse of overtrading. It means improper and under utilization of funds lying at the disposal of the undertaking. In such a situation the level of trading is low as compared to the capital employed in the business. It results in increase in the size of inventories, book debts and cash balances. Undertrading is a matter of fact an aspect of overcapitalization. The basic cause of undertrading is, therefore, underutilization of the firm’s resources. Such underutilization may be due any one or more of the following causes:

Conservative policies followed by the management; Non-availability or shortage of basic facilities necessary for production such as, raw

materials, power, labour, etc; Genera l depre ss ion in the marke t r e su l t ing in fa l l in the demand of

company’s products;

The symptoms of undertrading are the following:( i ) A v e r y h i g h c u r r e n t r a t i o ;( i i ) L o w t u r n o v e r r a t i o s ;( i i i )An increa se i n work ing cap i ta l tu rnover (work ing cap i ta l / sales) ratio.

Consequences of undertradingThe following are the consequences of undertrading:

(i) The profits of the firm show a declining trend resulting in a lower return on capital employed (ROI) in the business.

(ii) The value of the shares of the company on the stock exchange starts falling on account of lower profitability;

(iii) There i s los s to the repu ta t ion o f t he f i rm on accoun t o f lower profitability and creation of impression in the minds of investors that the management is inefficient.

Remedies for undertradingThe condition of undertrading is set in because of underutilization of the firm’s resources. The situation can, therefore, be remedied by the management by adopting a more dynamic and result-oriented approach. The firm may go for diversification and undertaking new profitable jobs, projects, etc., resulting in a better and efficient utilization of the firm’s resources.