Good Debt vs. Bad Debt
utside of economists and financial officers I’m not sure many people like to talk too much about debt. Debt is often associated with poor planning or being in financial straits.
For a small business, there are times when it’s smart to use debt as a financing option. Knowing when is the tricky part. How do you make sure that your borrowing decisions don’t leave your business scrambling to pay bills—or you personally on the hook for years to come? There’s no one-size-fits-all rule, which is why so many business owners make mistakes. It usually comes down to case-by-case decisions.
Good debt is debt on assets that are earning income for you at a rate greater than the cost (interest) on the debt.
There is something called the “hurdle rate” to determine if an investment (and debt) is worthwhile. The hurdle rate is simply the cost of capital. If the hurdle rate is set at, say, 15% then only investments or purchases bringing in more than 15% would be considered “good debt”. If you are using a credit card for ‘good debt” you better have a great or quick return!
Let’s say you’re planning to sell T-shirts at a fair two weeks from now, buying them on credit will help keep cash on hand for other things. It’s something of a matching game, where you want to make sure long-term debt is matched with long-term assets and short-term debt is matched with short-term assets (purchases).
As a rule of thumb, short-term financing works for assets which will quickly convert to cash—such as products you’ll be selling in your store next week or those T-shirts for the fair. Just be realistic about how much you can sell. You might put $1,000 worth T-shirts on a credit card, but not $50,000. The idea of credit-card debt is that we want to pay it off every month. Let me say that again—the idea of credit card debt is that we want to pay it off every month.
In positive returns, good debt includes anything you truly need but cannot pay for in full without wiping out your cash reserves.
Purchasing equipment for your business would be a wonderful example of this kind of debt that might require a loan from a bank or other financial institution—or leasing. Most equipment pays for itself with the revenue it produces. Also, many pieces of equipment are very expensive and you have no other choice but to borrow, so structuring a lease or financing program with manageable monthly payments is a wise usage of good debt.
Credit cards are generally okay for emergency purchases. In fact, credit-card financing can be a lifesaver because it’s available quickly, without the long application process that comes with bank loans.
For most larger purchases, however, you’re better off looking at other financing options, as was mentioned, bank loans and leasing. What shape are your finances in? Don’t wait until you’re desperate for a loan to cover your company’s financial health. If you’re house is on fire, it’s probably too late to buy the fire extinguisher.
In opposition to good debt, bad debt does not create an income greater than the interest of the debt. But it’s more than that. You’ve perhaps taken on the debt of things you don’t need and can’t afford. Most of these purchases don’t just fail to produce a greater return than the interest expense, they produce no return at all! Most importantly—bad debt and the decisions that created the bad debt doesn’t help grow your business.
Your financial success in business and life will largely be determined by your ability to discern between good and bad debt. Embrace good debt. It will give the leverage needed to take your business to the next level, or simply to stay solidly solvent.
Again in each purchasing instance, make your decisions on a very case-by-case basis. Choose wisely.
Don't be afraid; be careful.
If you plan to borrow on credit cards that require a personal guarantee, or take a loan that requires you to put your house up as collateral, you need to take a close look at your personal finances. Will you be able to pay off your debts if the business hits roadblocks.
Be careful that you’re not relying too heavily on borrowing to fund your business. It’s important to have your own money or cash from investors to put into the business. If you’re growing, or sustaining, with debt, you’ve got a real problem. One hiccup and the whole thing falls apart.
Ask yourself and your business partners, “Do we need this? Do we need this now? Will this grow our business or keep our business competitive?”, and then apply honest answers. Bad debt creates many sleepless nights. Embrace good debt and you’ll sleep well.
by JOHN C. SMILEY