by Lyle Solomon, principal attorney for the Oak View Law Group
Building a business from scratch often entails incurring debt. To be honest, that does provide the initial investment required to develop products and cover overhead costs until the business runs smoothly.
Many startups have grown by leveraging the power of debt. However, taking out loans does not guarantee that your company’s finances will always be in your favor. Far too many startups have failed due to debt burden and an inability to repay it on time.
As an entrepreneur, you need to understand the difference between good debt and bad debt in the business. Otherwise, you may walk on the wrong path right from the start and get into financial trouble later.
What is good debt for a small business?
Good debt is the one that helps businesses to grow and develop. It could be a new loan for a new product launch or to buy necessary raw materials.
Good debt generates income for a business at a greater rate than the cost of the debt (interest). The hurdle rate is used by major businesses to determine whether an investment is worthwhile. The hurdle rate is nothing more than the cost of capital. If the hurdle rate is 30%, investments that bring a more than 30% return are considered “good debt.” If you’re going to use a credit card for “good debt,” you’d better get a good return!
A typical example of good debt is the use of funds to overcome a loss or crisis. For example, suppose an important piece of equipment in your business breaks down. In that case, it is feasible to borrow money at a low-interest rate to fix that machinery, as long as the losses avoided are equal to or greater than the overall cost of the loan. This includes interest, fees, and the principal amount.
In any case, and for whatever reason, good debt implies that you and your company will be financially strong in the end.
Aside from positive returns, good debt covers anything you need but cannot afford to pay in full without depleting your cash reserves. However, from a cash flow standpoint, you should borrow as per your affordability. Check if you can make the monthly payments on a new loan. Buying equipment for your business is an excellent example of this type of debt. Because most equipment covers its cost through revenue, streamlining a lease or financing program with affordable monthly payments is a perfect example of good debt.
There are two criteria for good debt. First, it should help to increase the net worth of your business. Second, it should have a low-interest rate. If you have a good credit score, you may qualify for a loan at a low-interest rate. However, if your payment history is full of missed payments or late payments, your credit score is bound to be poor. If you have too many debts, your best option is to pay them off as soon as possible. You can also consolidate debt into a single and affordable monthly payment plan. That would help you build a good payment history and rebuild your credit.
What is bad debt for a small business?
Debt that decreases your business’s net worth in the future is called bad debt.
Bad debt does not generate revenue more than the debt’s interest. It usually involves debt incurred for items you do not require and cannot afford. Most of these items not only fail to generate a better return than the interest expense, but they also fail to produce any return at all! Some even lead to huge losses in the business. In simple words, bad debt does not help your business to grow.
Bad debts also include loans you made to employees or stakeholders that you can no longer collect on and additional debts you must incur to repay the money you previously owed. Bad debts are frequently the result of a poor financial management system, which can stifle your company’s growth and even lead to its demise.
Debt consolidation loans elicit varying responses regarding how “good” or “bad” this type of debt is from a financial wellness standpoint.
Debt consolidation is an effective debt relief method and business management strategy to repay loans at low-interest rates and on the most flexible terms possible. However, a debt consolidation loan won’t help in case of poor business planning or excessive borrowing.
Replacing your debt with a consolidated loan to go back into debt is simply a wrong financial move. A debt consolidation loan, when used correctly, is an excellent way to manage your small business debt.
The bottom line
The ultimate question is this. Will this new debt pay you more in the long run than what you put in?
It appears to be a simple question, but it may necessitate some thought. Does the debt still make sense after calculating principal repayment and interest payments? If not, consider it as a bad debt. If yes, then it is good debt. You can put your money and time into it.
Good debt helps to generate revenue, whereas bad debt overall net value of your business. Just engrave this point in your heart, and you will be good to go.
Lyle Solomon has considerable litigation experience as well as substantial hands-on knowledge and expertise in legal analysis and writing. Since 2003, he has been a member of the State Bar of California. In 1998, he graduated from the University of the Pacific’s McGeorge School of Law in Sacramento, California, and now serves as a principal attorney for the Oak View Law Group in California.