Good Debt vs Bad Debt for Business Owners: How to Tell the Difference

Most businesses have needed to borrow at least once; however, not all borrowing is created equally. Some of them are good, but some become bad debt for the businesses. When the debt provides a return that exceeds the cost, that is good debt; whereas if a debt continues to consume cash for extended periods, that is bad debt. 

Learn more about good and bad debt in this article, which are best for the company and how you can manage the debt. 

What Makes Debt “Good”

In general, good debt allows a business owner to acquire something that produces additional income greater than the cost connected with the item. For example, a business owner who purchases a piece of machinery that enables the business to complete jobs quicker/cheaper and consequently increases sales has incurred good debt.

Additionally, timing is also important; good debt usually has a similar lifecycle to the item obtained. An example of this would be a 5-year loan to purchase equipment that will produce increased revenue over the course of the next 10 years. As long as the asset remains functional during its lifecycle, it will continue to generate sufficient proceeds to support the business after the loan is repaid.

Other examples of good business debt include:

• Equipment or vehicles that improve a business’s ability to produce/deliver more product
• Stock purchased during a non-busy season that can be reasonably projected to sell during the upcoming busy season
• Real estate purchased at a lower cost than borrowing
• Funding provided to conduct a confirmed contract with defined payment terms

Productive Assets: A Closer Look

One of the best examples of effective assets is trucks. Trucks are often used by courier or delivery companies to transfer goods. When a courier company uses borrowed money to obtain another truck, they create opportunities to accept more deliveries/routes and consequently attract more customers.

In essence, borrowed money is used to increase output and create additional sources of revenue. A productive benefit creates additional revenue through increased sales volume.

An example of this is a courier company that applied for financing for a second truck. Though truck finance rates were higher, the added productivity generated sufficient further revenue that the new truck was able to pay for itself in just a few months.

To validate the concept of a productive asset producing sufficient additional revenue to offset loan repayments, one needs to execute financial calculations:

• First, add up the estimated additional revenue generated by securing the productive asset.
• Second, subtract the estimated expenses connected with operating the productive asset (e.g., fuel, insurance, registration, maintenance, etc.).
• Third, subtract loan repayments from net income. 
• Fourth, if the result is clearly positive, then the developed asset generates sufficient additional revenue to validate the loan.
• Fifth, if the resulting profit is minimal, any significant changes in variables can lead to negative benefit (e.g., a slower-than-average month, rising fuel prices, an unexpected breakdown).

What Makes Debt “Bad”

Bad debt is described by borrowed money being spent on an item or service that does not produce enough additional revenue to offset loan repayments. In effect, borrowed money consumed monthly without generating new income is confidential as bad debt. Common types of bad business debt include:

• Using a credit card or deficit facility to finance continuing operational losses.
• Acquiring items that rapidly reduce and/or do not generate revenue.
• Short-term, high-interest-rate loans used to meet instant obligations.
• Long-term loans associated with purchasing assets that do not remain efficient throughout their lifecycle.

Although emergencies may require temporary bad debt (credit cards, overdraft facilities, short-term high-interest loans), chronic reliance upon bad debt can cause financial distress. Another type of debt is referred to as suppositional borrowing since it depends upon future increases in value or revenue streams.

Speculative Borrowing

Speculative borrowing represents an investment approach whereby borrowers utilize borrowed monies to speculate on investments expected to increase in value. If successful, the supposition results in a higher return on invested capital than the cost of borrowed funds. However, if unsuccessful, inference borrowing results in the borrower losing both principal and interest owed on borrowed funds.

Examples of speculative borrowing include buying gold stored in bullion vaults expecting price appreciation; investing in equities, cryptocurrencies, or real property exclusively based on projected future appreciation; and purchasing real property anticipating resale at a higher price.

When utilizing speculative borrowing strategies, it is prudent for entrepreneurs to avoid using borrowed funds whenever possible and rather depend on surplus cash resources for suppositional purposes. Failure to follow this strategy places entrepreneurial enterprises at risk due to potential loss of security securing borrowed funds.

Warning Signs That Good Debt Is Turning Bad

Even though a particular loan initially represents a reasonable decision, it can ultimately deteriorate over time. Numerous measures identify when a previously viable loan has turned bad. For example:

• Repayments are being covered by application of overdraft facilities.
• Additional borrowing is occurring to meet existing loan obligations.

Distinguishing and addressing these warning signals early in their development reduces long-term risks to an enterprise and improves overall sustainability.

If an enterprise finds itself carrying surplus inventory or owning equipment that no longer generates enough revenue to support loan repayments, it may be prudent to consider selling/renting/utilizing the supplies in alternative ways that maximize value and minimize financial liability.

Questions to Ask Before You Borrow

Before agreeing to any new loan agreement(s), conduct an introductory assessment of proposed advancing arrangements by asking yourselves:

• Will this suggested loan arrangement assist my business in generating revenues to repay extraordinary loan repayment amounts?
• Does the proposed loan term align with the expected duration of productivity provided by the acquired asset/benefit?
• Can my business sustain loan repayments even in lagging sales months?
• What is the total cost of the proposed loan preparations (interest charges + fees + balloon payment)?
• Are there substitute methods available for achieving comparable objectives (leasing/deferring)?

If you are unable to respond positively relating to most of these questions, confer with your certified public accountant (CPA) prior to committing to any form of lending arrangement. Your CPA can facilitate you in modeling cash flows relative to substitute lending arrangements and comparing various financing alternatives against one another.

Managing the Debt You Already Have

Many business owners have multiple loans outstanding at any given time. Conducting a rapid review of current outstanding balances can highlight those loans accessory to growth and those that are inhibiting progress. List each outstanding loan with its particulars:

• Outstanding balance
• Interest Rate
• Monthly Payment
• Asset/Benefit Purchased with Loan Proceeds

Then sort the listed loans according to divisions (productively contributing / unproductive). Loans connected with productive assets that continue to contribute significantly to gross profits are usually safe candidates for continued existence, while those related to high interest rates that offer little or no contribution should be evaluated for refunding or elimination.

By refinancing high-interest-rate loans or eliminating them via accelerated repayment using excess cash reserves, you can create considerable savings in monthly cash expenses.

Keeping Debt in Proportion

Businesses should develop habits of tracking and monitoring specific standards every quarter (at minimum). Contemplate tracking total enterprise-wide debt levels relative to general enterprise-wide asset values every quarter. Also consider measuring monthly repayment totals relative to monthly earnings totals. If either measure suggests increasing faster than corresponding trends relating to gross income generation, it may be advisable to reduce new borrowing activity.

Financial institutions assess similar data points when contemplating applications for funding. Therefore, maintaining healthy ratios will also smoother easier access to competitively priced funding when necessary.

Borrowing With Confidence

Borrowed money is merely a tool – not evidence of how well your business is performing financially. Borrowed money can be efficiently leveraged when applied towards assets/products that create gradual revenue streams greater than the expense burden linked to the asset/product. Borrowed money is effective when it supports assets/products with settled returns and sustainable cash inflows.

Whether or not the loan you secure is good depends on what you are spending the money on and how long you intend to keep it. The key is how much money you can afford to spend each month on loan repayment and understanding how changing circumstances may impact your capacity to continue making timely loan repayments.

FAQs

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