For business owners, the word "debt" often makes us feel anxious. However, debt itself isn't inherently bad. It’s how we use it that determines whether it becomes a stepping stone to growth or financial trouble.
What is Good Debt?
Good debt is like a strategic tool that, when used correctly, can significantly enhance our business’s growth. Good debt is like borrowing money to buy a reliable car that will get you to work faster every day, enabling you to earn more. It’s a calculated investment aimed at increasing your revenue or improving your business’s value. Here are some examples of good business debt:
1. Loans for Expansion
Imagine you own a small bakery that’s doing well in your neighborhood. You've got a steady stream of customers, and the profits are growing, but you’re running out of space. You’ve identified another location that would be perfect for a second branch, but it’s going to cost more than you currently have in the bank. Taking out a loan to expand your business is considered good debt because it allows you to grow your business and serve more customers, thereby increasing your revenue and profitability over time.
2. Investing in Assets
Let’s say you’ve been renting baking equipment for years, and you realize that buying your own ovens and mixers would save you money in the long run. A loan to purchase these assets is good debt. These assets can not only increase your operational efficiency but also appreciate in value over time, making them a sound investment.
3. Working Capital Loans
Seasonal businesses often face cash flow shortages during off-peak times. For example, if you run a Christmas decorations store, your peak season is just a few months. A working capital loan can help you cover expenses like rent and salaries during slower months without draining your savings. This type of debt helps bridge the gap between revenue cycles and keeps your operations smooth.
What is Bad Debt?
Bad debt, on the other hand, is like borrowing money to buy a luxury car you can’t afford, just to impress your friends. It may look good on the surface, but it doesn’t improve your ability to earn more money and, in fact, can make it harder to manage your finances. Here are some examples of bad business debt:
1. High-Interest Loans for Everyday Expenses
Picture this: it’s the end of the month, and you’re short on cash to pay your staff or rent. You decide to use a your personal credit card with 24% interest to cover the shortfall. This is bad debt. Using high-interest loans for everyday expenses can quickly spiral out of control. The interest compounds, and before you know it, you’re stuck in a cycle of borrowing more just to keep up with the repayments.
2. Unplanned Borrowing
Imagine you’re at a business networking event, and you meet someone offering a “great deal” on marketing services. You don’t have the budget, but you take out a loan to pay for it, thinking it will pay off. Unfortunately, without a clear plan or strategy in place, this borrowing is risky and can put unnecessary strain on your finances.
3. Debt for Non-Essential Purchases
Suppose you’ve had a good month, and you decide to borrow money to renovate your office with luxury furniture and a state-of-the-art espresso machine. While it may impress visitors, it doesn’t contribute to your business growth or profitability at all. This is akin to borrowing money to buy a Rolex when you’re struggling to pay bills. It’s a luxury you can’t afford and doesn’t add value to your core operations.
How to Determine if Debt is Good or Bad
Making smart borrowing decisions in business comes down to understanding the purpose and potential return on investment (ROI). Ask yourself these questions before taking on any debt:
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Does this debt help my business grow or improve? If the answer is yes, then it might be considered good debt. For example, borrowing to upgrade equipment that will improve productivity or to expand into a new market with proven demand.
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Can my business afford the repayments without straining cash flow? Good debt should be manageable. If you’re stretching your cash flow too thin to make repayments, it might not be worth it.
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What’s the interest rate and repayment term? A lower interest rate over a longer term is more manageable and often characteristic of good debt. High-interest, short-term loans can quickly turn into bad debt.
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Do I have a clear plan for how this debt will generate income? Borrowing should never be based on a whim. There must be a concrete plan for how this investment will pay off.
Case Study
Our client is a coffee shop owner named John (name has been changed).
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Good Debt: John’s coffee shop is bustling, and customers love his coffee, but the lines are long, and he can’t serve everyone fast enough. John decides to take a loan to buy an extra espresso machine and hire another barista because most of his customers do takeaways. The extra equipment and staff help him serve more customers quickly, increasing his sales and profits. If his customers were mostly dining in and he has a space constraint, the investment wouldn't have made sense. This is good debt because it directly contributes to his business growth.
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Bad Debt: On the other hand, if John decides to take out a loan to refurbish his shop with expensive Italian furniture that doesn’t attract any more customers, this is bad debt. His profits don’t increase, but now he has a hefty loan to pay off. It doesn’t generate any additional revenue or value for his business.
With our help to improve his financials, John was able to finally qualify for bank loans and could borrow at an affordable interest rate. Before that, John was always relying on private lenders whose high interests eroded whatever profits he made and more.
Conclusion
Understanding the difference between good and bad business debt is crucial for any business owner. Good debt is an investment in your business’s future growth, while bad debt can be a heavy burden that hinders your progress. Always evaluate our purpose and potential return of any borrowing decision, and ensure it aligns with our business goals. By making informed choices, we can use debt as a powerful tool to fuel our business's success rather than a chain that drags it down.