Overcapitalization and Overtrading

The finance manager must be wary of two polar extremes in working capital management. These extremes are,

  1. over-capitalization and,
  2. over-trading.

1. Over Capitalization (Conservative Financing Strategy)
If a company manages its working capital, so that there are excessive stocks, debtors and cash and very few creditors, there will be an over-investment by the company in current assets. Working capital will be excessive and the company is said to be overcapitalized (i.e. the company will have too much capital invested in unnecessarily high levels of current assets). The result of this would be that the return on investment will be lower than it should, with long-term funds unnecessarily tied up when they could be more profitably invested elsewhere. Indicators of over-capitalization

Accounting ratios can assist in judging whether over capitalization is present.

  • Sales/Working capital ratio: – the volumes of sales as a multiple of working capital should indicate whether the total volume of working capital is too high (compared to the past and industry norms).
  • Liquidity ratio:- A current ratio and a quick ratio in excess of the industry norm or past ratios will indicate over-investment in current assets
  • Turn-over periods:- Excessive stock and debtors’ turnover periods or too short creditor payment period might indicate that the volume of debtors and stocks is unnecessarily high, or creditors’ volume too low.

2. Over-trading (Aggressive Financing Strategy)
Overtrading occurs when a business tries to do too much too quickly with too little long-term capital: The capital resources at hand are not sufficient for the volume of trade. Though initially an over-trading business may operate at a profit, liquidity problems could soon set in, disrupting operations and posing insolvency problems.

Symptoms of over-trading
Accounting indicators of overtrading include:
(1) Rapid increases in turn-over ratios (over-heating)
(2) Stock turnover and debtor’s turnover might slow down with consequence that there is a rapid increase in current assets.
(3) The payment period to trade creditors lengthens
(4) Bank over-drafts often reach or exceed the limit of facilities offered by the bank.
(5) The debt ratios rise
(6) The current ratio and quick ratio fall and the net working capital (NWC) could be negative.

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