What it means
Working capital is current assets minus current liabilities, the money tied up in stock and customer invoices less what suppliers and short term lenders are owed. Every extra sale usually consumes some of it, because you buy materials and pay staff long before the customer's payment arrives.
The ratio therefore describes how hard the available working capital is working. A figure of 8 times means the business turns over its net current assets eight times a year, and a jump to 15 times means it is now supporting nearly twice as much trading on the same base.
It matters because overtrading is invisible in the profit and loss account. Revenue and profit both look excellent while the cash position quietly deteriorates, and the problem usually surfaces suddenly as a missed payroll, a stopped supplier account or a breached overdraft limit.
Supporting signals should always be read alongside the ratio. Rising debtor days, growing stock, an overdraft that never returns to zero and increasing reliance on stretching supplier payments together confirm what a rising ratio suggests.
There is no universal safe level, since the right number depends on the industry and the payment cycle. A supermarket collecting cash instantly and paying suppliers in 60 days can run comfortably on negative working capital, whereas a contractor with long payment terms needs a much lower ratio to survive.
In practice
Real-world examples.
Example
A recruitment agency doubles its contractor book in six months. It must pay contractors weekly while clients pay in 45 days, so the ratio leaps from 6 times to 14 times and the agency has to arrange invoice financing to keep paying its people.
Example
A food producer wins a national supermarket listing and celebrates a tripling of orders. The buyer demands 75 day payment terms, working capital turns negative, and the producer has to raise equity within four months to fund the stock the contract requires.
Example
A machinery dealer notices its ratio climbing steadily even though revenue is flat. The cause is falling working capital rather than rising sales, as slow moving stock is written down and the overdraft grows, which is an equally serious warning.
Think of it
“Overtrading means growing too fast for your capital-expanding beyond what your resources can support.
Formula
Calculation
Overtrading ratio = revenue / working capital, where working capital = current assets - current liabilities
A commercial fit out contractor grows revenue from $8,000,000 to $12,000,000 in a year. Last year its current assets were $2,500,000 and current liabilities $1,500,000, giving working capital of $1,000,000 and a ratio of $8,000,000 / $1,000,000 = 8.0 times.
This year current assets are $3,000,000 and current liabilities have climbed to $2,200,000 as the company leaned on suppliers and its overdraft, so working capital is $3,000,000 - $2,200,000 = $800,000. The ratio is now $12,000,000 / $800,000 = 15.0 times, meaning 50% more revenue is being supported by 20% less working capital, which is a clear overtrading signal even though the company is reporting record sales.Case study
Seen in the real world.
The following is an illustrative and entirely fictional story. Ridgeway Interiors, an invented commercial fit out firm, grew from $8,000,000 to $12,000,000 of revenue in a single year on the back of three large office refurbishments. Every board meeting reported record turnover and a healthy 7% net margin.
The fictional finance manager plotted the overtrading ratio and found it had moved from 8.0 times to 15.0 times while debtor days stretched from 45 to 71 and the overdraft, once cleared each month, had become permanent. The profit was real but it was sitting in unpaid invoices and half finished sites rather than in the bank.
Ridgeway's illustrative response was to slow down deliberately. It asked for 20% deposits on new contracts, introduced monthly rather than end of project invoicing, and declined one large job with 90 day terms. Revenue growth in the following year was a modest 6%, the ratio settled near 9 times, and the overdraft was cleared for the first time in eighteen months.
Watch out
Common mistakes.
- Assuming that rising revenue and healthy profit mean the business is safe, when overtrading destroys companies that are profitable on paper.
- Reading the ratio in isolation instead of alongside debtor days, stock levels and the overdraft balance, which explain what is actually driving it.
- Solving the problem by borrowing more short term, which funds the growth for a quarter but leaves the underlying cash cycle untouched.
Questions
People also ask.
Is a high ratio always bad?
No, an efficient business with fast cash collection can support a high figure safely, so the trend and the payment cycle matter more than the level.
What is the fastest way to reduce overtrading?
Take deposits, invoice sooner, chase debtors harder and slow the rate of new order intake until the cash cycle catches up.
Can raising more equity solve it?
It buys time and capacity, but unless the cash cycle itself improves the same problem returns at a larger size.
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