It’s the Vibe (On Overtrading)

Posted by on Apr 11, 2014 in Academic Research

The truth is in the cash flow

It’s the Vibe (On Overtrading)

Do you remember Dennis, suburban solicitor and defender of the common man from the 1997 movie, “The Castle”?  Hopelessly out of his depth, he represents the Kerrigan family in court, to save their home from compulsory acquisition. In making his closing argument, Denis utters these immortal words “…in summing up, it’s the constitution, it’s Mabo, it’s justice, it’s law, it’s the vibe and uh, that’s it, it’s the vibe”.

I was reminded of that scene the other day, when I found myself musing over the difference between growth and overtrading. The train of thought had popped into my head because I have recently been helping owners of small and medium-size businesses that are undergoing rapid growth. I first heard the term “Overtrading” in 1988-89, just prior to the last prolonged recession in Australia. Whilst the “vibe” of the term was always clear, nobody I was working with at the time, or since, could cogently define overtrading for me.

Now, SME owners generally want to grow their business, but overtrading can quickly become fatal for a small or medium-sized business with only limited access to new capital (ie: new debt or new equity). In a 2011 research paper by Johan Van Der Spuy and Gideon Nieman, both of the University of Pretoria, they cite South African based research from 2007 where overtrading is listed as a cause of bankruptcy in 47% of cases.

With these thoughts in my head, I wondered, when does business growth morph into overtrading? What signs will help the owner of a small or medium-size business know that they are overtrading? And, how can the owner rectify overtrading?

In this article, the first of three, I will offer the SME owner (and their advisers) an answer to the first question. The second will help the SME owner identify when they are overtrading before it becomes fatal, and the third will set out for the SME owner the actions they can take to mitigate the effect of overtrading.

There is very little research on overtrading, other than the paper I mentioned earlier. In it were a couple of comments that I found particularly helpful in establishing a definition for overtrading:

  1. Overtrading…is the rapid growth of a business in which such strain is placed on the business’s capacity and/or resources, that when something (small) goes wrong the entrepreneur cannot deliver and problems grow in frequency.
  2. The…sustainable growth rate of a business, is the rate at which a company can grow without creating a cash flow problem.

The message for an SME owner (and their advisers) is that overtrading is incredibly dangerous to their business. It occurs when growth reaches a pace that overwhelms the physical resources of their business such that the quality of the product(s) or service(s) provided suffer and/or when growth reaches a pace that overwhelms the financial resources of the business creating cash flow problems.

Join me in my next post to find out how to recognise the symptoms of overtrading before it fatally damages your business.