AI Tutor
Imagine your business just landed a massive million-dollar order, profits look incredible on paper, but within three months your bank account is empty and you cannot pay your staff.
This nightmare scenario is called overtrading, which happens when a business expands its operations too rapidly without enough working capital (the day-to-day cash and liquid resources needed to fund operations).
How can a company make booming sales and still go completely broke?

The Anatomy of a Liquidity Crisis

When sales surge, you must buy raw materials, pay factory wages, and hold larger inventory long before the customer actually hands over any cash.
If customers buy on credit, your wealth gets trapped in trade receivables (money owed to you by customers), leaving you unable to settle your trade payables (money you owe to suppliers).
This mismatch destroys liquidity (the ability to pay immediate short-term obligations) and ultimately threatens solvency (the long-term survival and ability of a firm to cover all liabilities).
So how can an accountant spot overtrading on financial statements before the cash runs out?

Spotting the Warning Signs

Let's examine Apex Gear Co., a wholesale supplier whose sales increased by 80% in one year.
To diagnose their financial health, we check two liquidity measures: the current ratio (current assets divided by current liabilities) and the acid-test ratio (liquid current assets excluding inventory divided by current liabilities).