What is overextension?
Overextension definition refers to a financial situation in which a consumer or a company have more debts or loans than they can pay.
Overextension occurs when a consumer or business must pay back a debt with more than one third of their income.
If not addressed, overextended conditions can have repercussions and take a toll on the health of a business or personal finances.
Some of the adverse consequences of overextended conditions include piling late fees due to inability to pay debts; downgrading creditworthiness; inability to secure capital for purchasing supplies; and loss of business/personal credibility, all of which have multiple consequences.
Also, overextension means excess leverage in a trader and investor’s account equity and their buying power. This type of overextension can greatly magnify losses and force the trader to meet steep margin calls. Inability to do so may result in forced liquidation of securities and account freezing.
What does overextension mean?
An overextension example is when a person has a monthly salary of $3,000 but has to spend $1,000 for paying several loans. The same principle also applies for a company with debts that exceeds its earned net income.
Overextension in the economic conditions can also occur when a country’s economy is experiencing a downturn, causing even financially sound companies to become overextended.
For instance, the ongoing debt crisis faced by Chinese property company Evergrande (3333). The company has been facing an excess debt of $300bn (£229bn).
In its interim six-month financial report ended June 2021, the company reported 10.49bn yuan $1.65bn) of net profit and a whopping 571.77bn yuan ($89.85bn) of borrowings.
Evergrande’s inability to service its debt prompted Fitch Ratings in December 2021 to downgrade the Chinese homebuilder’s creditworthiness rating to ‘RD’ (Restricted Default), from ‘C’.
The debt crisis faced by Evergrande started last year when the Chinese government tightened borrowing rules to bring down leverage levels of the country’s builders that had been built up during a decades-long property boom. Evergrande’s crisis spilled over to the country’s property sector with more Chinese property companies defaulting on their overseas bonds.
Even in a healthy economic environment, overextension can happen. For example, conventional retailers struggled to compete with e-commerce retailers, despite other sectors in the economy growing.
Ways to resolve overextended conditions
To resolve the overextended conditions, companies or individuals can consolidate debt into a single loan. However, granting credit to overextended individuals or companies is risky.
A company can also raise capital. It can launch fundraising to service its debts, for example, by issuing new shares rather than taking on additional debt.