Imagine that for the next quarter your turnover doubled from £60,000 to £120,000. To achieve the extra turnover you had to purchase product that cost you £60,000.
On the face of it this is great news for your business. In three months you will have generated £60,000 (Sales of £120k less direct costs of £60k) of additional profit for your business. In this example we are going to assume that there were no increases in your fixed costs. Unfortunately, business up to this point has not been good and at the beginning of this exceptional quarter’s trade increase your overdraft is almost at maximum – you are £20,000 overdrawn and your limit is £25,000.
In order to buy the additional product you agreed to pay thirty days after invoice date. You were not in a position extend these payment terms as you were not purchasing for stock but to meet sales orders as they were placed. However, you advised your customers that they would need to pay you within thirty days. Quite reasonably, you were reassured that cash inflow each month would more than cover cash outflow and all would be well.
At the beginning of the second month you needed to pay your suppliers £20,000 and as planned you received £40,000 from customers. Your bank manager was pleased.
At the beginning of month three of the quarter you were obliged to pay your suppliers a further £20,000 but this time half of your customers were a week late paying you and the rest advised you that they would need to pay after sixty days due to their own cash flow problems. So for that week you had to use most of your overdraft facility.
At the beginning of month four you were unable to pay your suppliers as agreed as all your customers pushed to extend their payment terms to sixty or even ninety days. You had very little room to manoeuvre. In order to continue trading you needed to pay suppliers otherwise they would withhold deliveries for month four. Your bank was unable to increase your overdraft as you were unable to offer further security and in the time available you could not raise additional private funds to introduce into your business.
Even though on paper you had generated £60,000 of additional profits cash flow was a nightmare. Overtrading is the term used to describe this type of short-term trading crisis that is created by sudden boosts in sales volume.
In order to work your way through these issues you need to plan ahead. Not only do you want to demonstrate that you are going to make more profits, you must also work out how and where you are going to find the cash flow to support the increase in trade. Otherwise…
If you want to set up effective cash flow management for your business we can help. Don’t wait until you have exhausted your working capital. Planning is the key to surviving short term overtrading conditions.