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An overtrading scenario

The timing of inflows and outflows can be crucial

A car company assembles vehicles in Europe. It receives an enquiry about supplying an additional 500 cars for a US dealership. It does its calculations and estimates, that even with additional transport costs it will make a 12% profit on every car sold because it has surplus capacity. It accepts the order and waits for the extra profits to roll in. However, they have not examined the cash flow situation.

Just like the majority of manufacturing firms the car assembler makes the cars and pays for all production costs well before they see any inflow of money from sales. The US dealership insists on delivery of all 500 cars before being invoiced. This will take 2 months.

Assume the car manufacturer:

  • pays labour at the end of each week
  • pays energy bills monthly
  • orders the parts two weeks in advance and pays for them 3 months after receipt
  • pays additional miscellaneous expenses throughout the production period

The US dealership receives all 500 cars after 2 months, but then uses the full 3 month credit period before paying the total order value.

So despite the each car making a profit, the manufacturer has cash outflows for up to 5 months, before receiving any cash inflows. The question is whether the firm has sufficient liquid assets to fund this production for the entire period. The negative cash flow could destroy the business. If they cannot pay their bills, their factory may be closed before they finish the order. The greater the rate of expansion of sales, the greater the adverse difference between inflows and outflows and the greater the potential cash flow problem. Success can be very expensive!