Good Debt? Bad Debt? Here's The Catch...

Have you ever borrowed money for your business? The majority of small business owners, at some point in time, either wanted or needed to pay for something without having the cash to do so.

As an example, let’s suppose you’ve borrowed money from a financial institution to purchase new equipment to speed up product production. You’re now “indebted” to pay that money back (“debt”) plus interest to this financial institution. With that being said, most people would assume that having debt is a bad thing, mainly because nobody wants to be “indebted” to someone else or to a financial institution, in that case. But wait a second... What if that borrowed money was invested in a way that made your business even more money? What if you become indebted for only a short period of time, your business makes more than enough money to pay it all back, and you still have a good amount of money left in the bank to continue to grow your business? Does that sound like a bad idea? Not necessarily. There are debts that could have a very positive outcome!

The financial health of your business, along with a few other indicators, is the main differentiator factor between GOOD DEBT and BAD DEBT.

“Debt” is universally known as something (usually money) that we borrow today and pay it back with interest in the future. The most important thing isn’t to understand its definition, but to have a solid understanding of its consequences.

• GOOD DEBT has the potential to increase your business’ net worth. It simply has future value.
• BAD DEBT might leave your business empty handed. It doesn’t add to your business’ net worth, especially if the item purchased with the borrowed cash gets consumed or depreciated.

In the examples below, you’ll be able to see the differences between good and bad debt in business:

1. Commercial Real Estate Loan

You get a mortgage today to buy the space where you’re establishing your company or the land where you’re going to build it. In 15-30 years, when the mortgage is paid off, the real estate could be worth two or maybe three times its purchase price. Good investment!

2. Small Business Loan

You go to a bank with your business plan and ready to be indebted to that financial institution for a few years. You invest that loan into expanding your business by buying more advanced equipment with new technology that makes the production process more efficient, you expand to a second location, and build a full e-commerce platform to boost sales. These actions are allowing your business to increase its margins and revenue. Now, you can pay back what you borrowed (plus interest, of course) and have a more robust business with a larger footprint.

3. Business Line Of Credit

It provides your company with a fixed amount of money you can use for short-term operating expenses, such as paying suppliers or your employees (payroll). What if your equipment breaks down? What if it runs up a large repair bill? You’d want to be prepared to cover those expenses immediately and get your operations back up and running as soon as possible. A business line of credit is critical and enables your business to take advantage of any opportunity that may arise or to be fully prepared to face unexpected events. It allows you to borrow only what you need, up to your credit limit, and only pay interest on the money you have borrowed. As long as you can qualify and use the line of credit responsibly, it can be one of the best tools available to your business.

4. Corporate Credit Card

Having a corporate credit card could definitely help you manage your business expenses. In fact, there’s no downside to using a corporate credit card for business purchases as long as you commit to paying off the debt before it accrues interest. A great benefit to using a corporate credit card: the rewards and perks. Let’s say you own a restaurant and would like to invest $15,000 on a brand new custom-built charcoal BBQ pit/grill/smoker. Even though you had the cash to pay for it, you decided to use your corporate credit card with a rewards program that earns you 3% cashback on purchases. Now, the $15,000 worth of equipment only ended up costing you $14,550—literally $450 in savings! Moreover, since you have the cash to cover this purchase, you can proceed to pay the full balance of the credit card and not have to worry about any interests at the end of the month. That's a great way to manage credit card debt in business. Determining if this is considered a good or bad debt is fully dependable on how and what you’re using it for.

5. Debt Refinancing

Do you already have a business loan and you feel like you didn't get a good deal on it? Refinancing this debt commitment with a different financial institution could help you save A LOT of money by either lowering the monthly payment amount, the interest rate, or adjusting its term. More cash in the bank would give you the opportunity to invest it back into the business, pay off your loan faster by making larger monthly payments, or give you peace of mind knowing your expenses are being reduced and your cash flow improved. On the flip side, if you refinance this debt commitment with a deal that's not significantly better than the one you currently have and you fail to effectively manage this debt by purchasing things that don't increase your business' net worth, then this could be considered a bad business decision.

6. Cash Loans

Taking out a cash loan or a payday loan to increase your company’s cash flow and cover expenses such as payroll, utilities, and rent might sound like a good idea if you ever find yourself in a deep hole. At the end of the day, you probably don't want to tell your employees that there’s no money left in the bank to cover their paychecks. The problem is that not only does this type of loan usually comes with an incredibly high-interest rate, but it also leaves you with nothing to show for it except a loan shark asking you for their money back. Large and serious financial institutions don’t even offer this type of service, to be honest, but I know there are options out there. In my humble opinion, stay away from it!

Think like an experienced investor and ask yourself, “What’s the return on investment if I use the borrowed money for this particular expense?” Is the answer less than what the debt will cost you? Then you might want to consider waiting and improving your cash flow operations. Alternatively, you could potentially consider selling off some of your assets, downsizing, or opening up your business to potential investors.

Analyzing the pros and cons of a new debt commitment and its outcome is critical for your business' financial health. In the long term, debt is simply money borrowed that you’ll have to pay back, and it can be just as great as it can be bad. The outcome of the situation (how you put that borrowed money to work and how you manage to pay it back) is what dictates the difference between great and bad debt in the business world. As long as you, the business owner, know your financials and plan ahead of time, you’ll be making the best possible business decision every single time. Don't hesitate to reach out to me for any guidance on your small business journey. Good luck!