Inventoriesinventories available to customers. The same point is broadly true for all businesses in
respect of all working capital aspects. It is obviously necessary not only that manage-
ment decides on the level of working capital that will be required, but also that it
ensures that it can finance that amount of working capital. Not to be able to provide
the level of working capital required to sustain a particular level of trading is known
as overtrading.Expansion and overtrading
Problems arise in practice for businesses that experience an expansion of trading
activity due to an upturn in demand, particularly when the increase in demand is
rapid and unexpected. The temptation to exploit profitable new trading opportunities
is frequently overwhelming. Yet increased activity without increased working capital
to sustain it can lead to serious overtrading problems, possibly culminating in the
business’s complete financial failure. At first sight the problem seems capable of solv-
ing itself, since the increased profits from the additional activity will provide the
finance necessary to expand the working capital. This view is usually misleading,
however, since the working capital requirement (additional inventories, additional
cash for labour and other costs) generally precedes any additional cash flows from the
increased activity. This arises from the fact that the typical business, irrespective of its
type of activity, has to pay cash to meet most of the costs of making a particular sale,
before cash is forthcoming from the customer. The extent of this problem varies from
one type of business to another. Clearly, it is a greater problem for a manufacturer
selling on credit, with relatively large inventories and trade receivables levels, than it
is for a business providing services for immediate cash settlement, for example a
hairdressing business. In fact, for a hairdressing business, rapid expansion of trading
may pose no overtrading problems at all. Put another way, manufacturers tend to
have long cash cycles whereas hairdressers do not.13.6 Inventories (stock in trade)
As we saw in Figure 13.1, manufacturing businesses typically hold inventories at vari-
ous stages of completion, from raw materials to finished goods. Trading businesses
(wholesalers, retailers and so forth) hold inventories in only one condition. Broadly
speaking, the level of investment in inventories by manufacturers tends to be relat-
ively large compared with that of traders.
Even with traders, there may be vast differences. A jeweller would normally hold
a much higher level of inventories (in value terms) than would a greengrocer with the
same level of annual turnover. The perishable nature of the greengrocer’s inventories
would partly account for this, as would the high value of the individual items in the
inventories of the jeweller. Another factor might be that when we buy jewellery we
usually demand a choice, which is less likely to be the case when we buy potatoes.
With many businesses the requirement for inventories varies with the time of year.
Firework manufacturers in the UK, who experience high sales volume in the period
leading up to 5 November, may well find it necessary to hold very large inventories
during each summer as they stockpile for the forthcoming period of high demand.
Irrespective of the nature of the trade, all businesses should seek to balance the costs
and risks of holding inventories with those of holding no or low levels of inventories.‘