In a preliminary report to the board of directors, the management consultants state: ‘Most of the difficulties faced by the business are symptoms of an underlying problem of overtrading.’

The most recent financial statements of the business are set out below:

Balance sheet as at 31 October 2007

£000 £000 Non-current assets Property, plant and equipment Land and buildings at cost 530 Accumulated depreciation (88) 442 Fixtures and fittings at cost 168 Accumulated depreciation (52) 116 Motor vans at cost 118 Accumulated depreciation (54) 64 622 Current assets Inventories 128 Trade receivables 104 232 Total assets 854 Equity Ordinary £0.50 shares 60 General reserve 50 Retained earnings 74 184 Non-current liabilities Borrowings – 10% loan notes (secured) 120 Current liabilities Trade payables 184 Taxation 8 Short-term borrowings (all bank overdraft) 358 550 Total equity and liabilities 854 7.8 275 CHAPTER 7 ANALYSING AND INTERPRETING FINANCIAL STATEMENTS Income statement for the year ended 31 October 2007

£000 £000 Revenue 1,640 Cost of sales Opening inventories 116 Purchases 1,260 1,376 Closing inventories (128) (1,248)

Gross profit 392 Selling and distribution expenses (204)

Administration expenses (92)

Operating profit 96 Interest payable (44)

Profit before taxation 52 Taxation (16)

Profit for the year 36 All purchases and sales were on credit.

A dividend was paid during the year on ordinary shares of £4,000.

Required:

(a) Explain the term ‘overtrading’ and state how overtrading might arise for a business.