Navigating Good Debt vs. Bad Debt In Business

Jolly Juggles the Clown and his circus team are booked for children’s parties, community festivals, and family events every weekend for the next 6 months. His community can’t get enough of their comedic, 10-clowns-in-a-tiny-car act during the grand finale of their performances. There is only one problem… they are turning customers away because they simply can’t accommodate any more parties. Jolly Juggles can't stand the thought of letting all of the kids down.?

But what, oh what, is a clown to do?

To expand Jolly Juggles’ business, he needs to buy a new clown car that can fit 10 more clowns (which he’ll also have to hire.) While his business is doing well, he doesn’t have the cash available to buy a new clown car outright. He’ll have to take out a loan, and that makes him…a sad clown. He doesn’t like having debt. He’d hate to see his business suffer, and maybe even go under, because of debt.?

Are you finding yourself in a similar situation? While you may not be wearing face paint and juggling during your day job, every successful business comes to a point where they need to make big financial decisions to grow their business. If you don’t have cash sitting around to make big purchases, taking on debt can be scary and many business owners delay the decision for fear of the financial risk involved. I’m ready to stand in as your financial juggler, taking a closer look at all the balls your business has in the air and guide you towards making the best financial decisions when it comes to taking on debt. Book a time with me for an initial conversation about good debt versus bad debt in business and how my services as a Fractional CFO can help you realize healthy business growth.

Understanding Good Debt vs. Bad Debt

When it comes to deciding if the debt you are about to make is good or bad, there is really one big question you need to ask yourself:?

Am I gaining a significant asset, which will grow my business or which I can sell later, in exchange for taking on this debt?

For personal finances, good debt is usually a house mortgage, a car loan, or education. Of course, any debt that you take on which is more than you can afford to pay back is actually bad debt. For example:

• If you buy a car and pay it off in 3-5 years with payments you can afford, that’s good debt. But if you took out a loan for 10 years in order to afford the monthly payment, that’s bad debt. By the time it’s yours, you spent way more on interest than you should have, and the resale value has plummeted.?
• If you take out a large college loan for a career that won’t have a high enough salary to support the monthly payments after graduation, that’s bad debt.
• Going into debt for meals, clothing, a vacation to the Bahamas to see Jolly Juggles perform live – that’s all bad debt.?

In business, the same principles apply but it’s a bit more complicated. Business finances have many layers to consider. Just like the clowns that keep falling out of Jolly Juggles’ clown car, the financial elements of business health are numerous and must be managed and weighed with care to usher your business to the next stage of growth.

When Is It OK To Take On Business Debt?

Generally speaking, the answer to this question lies in the return on investment. Let’s look at a few specific business examples of what you should consider before taking on debt.

Consider the interest rate. If you take out a bank loan, you’ll want your growth rate to increase by more than what it costs you to pay off the debt. If you take out a bank loan with 6% interest and you believe it will grow sales by 10%, then that is good debt. But how do you measure what percentage your sales might grow? This is what I like to call a calculated gamble – you hope your business will grow by 10%, but you don’t know for sure. It’s a guess that should be analyzed as much as possible to help you make the decision.

Consider the expense versus the potential profit. Jolly Juggles not only needs a second clown car for his business, he needs to hire 10 more clowns to fit inside said clown car. Not only will he need to take out a bank loan to pay for the car, he’ll need the loan to hire more clowns in order to meet the demand for booking more parties. For you, this might be buying a new car to make more in-person sales calls, while also hiring a new salesman to make those sales calls.?

It’s not obvious to everyone if this is good or bad debt. As your Fractional CFO and expert financial juggler, I would advise you to compare the interest rate on the loan to your expected rate of return for the car and hired help. You want people to pay for themselves long-term, so if you pay your new sales person $75,000 annually, then they need to bring in more than $75,000 in profit annually.?

To determine exactly how much more they should bring in to make it worth it, remember to include their salary, insurance, payroll taxes, retirement or 401k company contributions to calculate the all-in cost of this new hire. This is called the fully burdened labor rate (FBLR). Your profit from this new hire needs to cover the FBLR plus more to achieve a healthy return on investment.

Consider your cash flow. If you do have the cash available to pay for a new clown car – I mean, company car – outright, should you use your own cash to finance the purchase or is a loan the better way to pay for it? In this case, compare the loan interest rate to what you would be losing on your cash if you were to remove it from its current place of investment. If you are currently earning 6% on cash because it’s in an investment account, and a loan for the new car is only 2%, take the loan. It is smarter to take on the debt and pay 2% so you can leave your cash invested and earn 6%.? This gives you a net benefit of 4%! You want your money working for you, not against you.?

Consider the loan source. It’s unfortunate, but there are many lenders out there that would love nothing more than to take advantage of your business. Be wary of predatory lenders who offer “fast cash” and short-term loans. The interest rates and hidden fees can add up faster than you can say, “here comes Jolly Juggles and his 10 buddies in a clown car!” Read more about preventing this type of financial crisis in my article on accounting and cash flow tips for loans.???

Consider your taxes. In the last quarter of the year, your tax advisor may direct you to purchase significant assets before the end of the year in order to write off the cost of the item for that fiscal year. Respectfully, just because your tax advisor tells you to doesn’t mean it’s a good, overall business decision. It very well could be, but your tax advisor is looking out for your taxes and sees only the tax benefit. A Fractional CFO has the bigger picture in mind and can look at your financials from all angles to help you make the best decision.?

Side note - these tax rules have changed for 2023 and the next few years - the benefit has been reduced.? Talk to your tax advisor about what has changed.

Consider lease terms. I often get asked if a lease is the same thing as taking out a loan. Many businesses have the opportunity to lease a car or a copy machine, for example. It’s incredibly important to look closely at the terms of the lease. I can say with confidence that I’ve never personally seen a lease that I thought was worth it. You usually don’t get to keep it when the lease term ends, so you are not acquiring an asset after incurring an expense nearly equivalent to the original price. You are also limited in use: X amount of copies per year or X amount of miles driven per year. If you go over that amount, there are penalties. There are some leases where you have the opportunity to buy it after the lease is up, but you’ll need to run the numbers to determine if it’s a sound financial decision to make.?

Secure A Financial Partner To Navigate Good vs. Bad Business Debt

If you are looking to grow your business and have read this far, I applaud you for doing your due diligence to ensure you are making wise financial decisions! Managing business debt is incredibly important for the growth of your business and long term financial success. I’d love to learn more about your business and serve as your financial juggler. Contact me today to start the conversation.?