Good Debt vs. Bad Debt for Small Businesses: What’s the Difference?

Good Debt vs. Bad Debt: Small Business Guide

Is debt negative or positive for a small business? With the average small business carrying around $195,000 in debt, per Experian, and business debts skyrocketing in recent years, according to the Federal Reserve, it’s a question worth asking. However, the answer isn’t always clear-cut. On this page, we’ll explore how business debts work, go over some differences between good and bad debt, and cover how to get out of business debt if you’ve found yourself in an unfavorable situation.

What is the Difference Between Good Debt and Bad Debt?

Let’s begin by addressing the big question: “Is debt positive or negative?” It can actually be both. The key difference between good and bad debt is what it does for your business.

What is Good Debt?

Generally speaking, a “good” debt benefits your business in one or more of the following ways:

  • Can potentially increase the net worth of your business
  • Can potentially increase your net worth
  • Has future value

Additionally, some signs a funding solution might be good include:

  • Low-interest rates
  • Minimal start-up costs and origination fees
  • No annual fees
  • Manageable installments
  • Payoffs that can be made quickly

Furthermore, taking on good debt can boost your credit score as long as you keep up with your payments. That means you’ll have access to more loan options and better rates as you continue to strengthen your score, so your business saves money on big purchases like real estate and equipment.

What is Bad Debt?

A “bad” debt, on the other hand, has the potential to damage your business in the long run. This includes debts:

  • For items that are consumed or depreciate
  • That don’t add to your or the company’s net worth
  • That could potentially leave you with nothing to show for your payments

Additionally, some warning signs of bad debt loans include:

  • High-interest rates
  • Expensive start-up costs or origination fees
  • Annual fees
  • Unmanageable installments
  • Payoffs that are difficult or impossible to reach

Examples of Good Debt for Small Businesses

Based on the definitions, you may already have some idea of what a good business debt looks like. Some examples include:

  • Mortgages that provide you with an asset in the form of real estate
  • Small business loans used to help expand your business or operate more efficiently

Going by the definitions provided earlier, revolving credit and credit cards could fit into the good or bad debt category as well, but it depends on how you use the cash, the terms of the agreement, and your ability to pay off the debt quickly.

What to Consider When Making a “Good Debt” Investment

Before you take on debt you consider to be good, ask yourself the following questions:

  • Is this debt going to help my company grow stronger? Will it add value to my business and/or boost cash flow?
  • Am I paying the least amount possible to borrow?
  • Am I using historic data and realistic projections to determine my ability to pay the loan back?
  • Have I spoken with a tax specialist to determine which options are best to lower my tax burden?
  • If I’m using the cash for something like inventory or supplies that will allow me to accept more business, am I going to earn enough to pay the loan off and still profit?
  • Are the fees and interest for this loan reasonable? If not, do I have a solid exit strategy that will allow me to pay off the debt quickly to avoid excessive fees?

Examples of Bad Debt for Small Businesses

Now, let’s look at some bad debt examples your business will probably want to avoid. These include:

  • Credit cards and lines of credit with high-interest rates that won’t get paid off immediately
  • Merchant cash advances (MCAs) with high fees and unpredictable repayment schedules
  • Short-term loans intended to be paid off within 30 to 90 days that come with excessive interest rates and fees

Avoid Bad Debt: Making Informed Financial Decisions for Small Businesses

Navigating the financial landscape of small businesses can be challenging, especially when trying to discern the difference between good debt and bad debt. While good debt can help you build wealth, foster growth, and potentially improve your credit score, bad debt can drag down your business, burdening you with high-interest rates that stifle progress.

Take for example, credit card debt. Credit cards can be valuable tools when used wisely, offering opportunities to manage cash flow and even earn rewards. However, high-interest credit card debt can quickly become a problem, especially if you can’t pay off your balance in full each month. This type of debt is often considered bad debt because of the potentially crippling interest rates associated with it.

On the other hand, a mortgage or business loan might be seen as good debt. This type of debt, especially when it comes with a lower interest rate, allows businesses to invest in assets that can appreciate over time, like real estate or essential equipment. But even mortgages can shift from good debt to bad debt if the home prices decline or if the loan used is beyond what the business can afford, leading to potential financial struggles.

Another point of concern is student loan debt. While education is invaluable and can open doors to numerous opportunities, much student loan debt without a strategic repayment plan can hamper one’s financial situation.

Furthermore, while some consider auto loans and certain types of debt like “good debt” because they enable essential purchases, it’s crucial to keep in mind the repayment terms and interest rates. High-interest loans, for instance, payday loans, are often considered bad debt because of their exorbitant costs and potential to plunge borrowers into a debt spiral.

Experian, a renowned credit reporting agency, and other financial institutions, such as the Federal Reserve Bank of New York, emphasize the importance of debt management. Their reports and studies highlight the consequences of poor financial decisions and underscore the importance of understanding what’s the difference between debts that can boost net worth and those that detract from it.

Lastly, for small business owners contemplating taking on more debt, reviewing the annual percentage rate (APR) and evaluating if the debt used to finance specific ventures will have a positive or negative impact in the long run is crucial. After all, the ultimate goal is to leverage debt to foster growth, not hinder it.

What to Know Before You Take on Bad Debt

Business owners often know that taking on certain debts can hurt the business. For instance, if the loan comes with high interest and/or fees, and those are disclosed before signing, the long-term implications of accepting the loan are fairly clear.

The problem is that the solutions that businesses turn to when they’re cash-strapped and need to make payroll or cover inventory don’t generally fall into this category. That’s when people look into “quick money” solutions like revolving credit, MCAs, and short-term loans.  In these cases, the total amount that will be paid isn’t always clear. Sometimes it’s not even known because the amount is dependent on how much the business owner chooses to put toward the debt each month.

Moreover, because the cash isn’t going toward something that will grow the business, and the underlying issue that caused the cash shortage isn’t addressed, it’s almost a guarantee that the business will run into the same cash flow shortfall later. Only, the next time, it’s responsible for additional debt payments from the first loan too. This is how businesses get caught in a debt spiral, and once you’re in, it’s very difficult to climb back out.

How Much Debt is Normal for a Small Business?

Again, the typical small business presently carries $195,000 in debt. While that might be “normal,” it doesn’t necessarily mean that this level of debt is appropriate for your business. There are three common ways to evaluate business debt.

Ability to Make Monthly Payments

Simply put, if making the monthly payments on debt impact the business’s ability to cover other expenses like payroll, the business is carrying too much debt.

Debt-to-Income Ratio

Calculating a debt-to-income ratio similar to the one used in consumer markets may also be helpful. To calculate yours, add up all expenses you pay each month and divide the figure by your gross revenue, then multiply by 100 to get a percentage. An ideal rate is 30 percent or less. Anything over 50 percent means the business has an unhealthy level of debt and needs to take immediate corrective action. Businesses that land between 30 and 50 percent should work to reduce their debt.

Debt Service Coverage Ratio (DSCR)

DSCR works similarly to debt-to-income ratios.

The formula is as follows: DSCR = Earnings before interest, tax, depreciation, and amortization (EBITDA)/annual loan payments

A 1.0 ratio signifies that the borrower is at the breakeven point. They can pay their debt but would be in trouble if their financial situation changed. Anything less than that means the borrower will likely default. Anything higher signifies the borrower can handle the current debt load and may be able to handle more. Banks, for example, sometimes require that businesses maintain a DSCR of 1.25 when applying for a line of credit, Investopedia reports.

Managing Your Debt: How to Get Your Business Out of Bad Debt

Knowing the difference between good and bad debt can help you make smarter decisions when your business is short on cash, but what if you’re already in a difficult situation or caught in a debt spiral? The following business debt management tips can help.

Stop Taking on New Debts

Immediately stop taking on new debts. Taking out additional loans to cover expenses, even emergency expenses, will make it that much harder to correct the situation.

Analyze Your Budget and Financial Statements

You need to have a firm grasp on your revenue and expenses, as well as overall cash flow. Modern accounting software can take the guesswork out of this and help you identify when you’re likely to have a cash flow shortage so you can take steps to avoid it, and when you’ll have additional cash on hand to put toward debts.

Consider Consolidation

More than a quarter of small businesses applying for loans are doing so with the hope of refinancing or paying down debt, the latest Small Business Credit Survey finds. If you’re wrestling with high-interest loans, consolidating into a single payment with a lower interest rate is usually a good option, provided you qualify. You can also refinance a high-interest loan to reduce your payments and interest. Either way, be sure to crunch the numbers in advance, as you’ll generally pay fees to obtain the loan, and those can sometimes mean you’ll pay more to pay off the new loan than you might have if you’d just paid down your debts faster.

Triage Your Debts

Review all your current debts and find out what you’re paying for each one every month as well as what your interest rates and any recurring fees for each account entail. Generally speaking, it’s best to pay off loans with the highest interest/ greatest cost to borrow first. With this in mind, you’ll want to funnel every penny you can into your most expensive loan first until it’s paid off, then move to the next most expensive loan.

However, it can be disheartening to chip away at debt every month and not feel like you’re making progress. If you feel like the above approach is going to cause you to lose momentum, pay off your smallest balance first instead. When it’s paid off, funnel the money you would have put toward it to the next smallest balance. With this approach, the amount of extra money you’re putting toward a debt each month snowballs, so you can see the progress a little more clearly. You’ll likely pay more over the lifetime of the loans to use this approach, but if it keeps you motivated to pay off your debt, it’s a worthwhile expense.

Renegotiate Your Terms

Sometimes creditors are willing to renegotiate their terms. You don’t need to wait until you’ve missed a payment to ask. Just start calling creditors and tell them your business is experiencing hardship and needs to make changes. Some will offer to wait for payments or reduce payments. That can be helpful if you’re struggling to pay each month or they’re low-cost, and you want to put extra cash toward high-cost loans. However, it will increase the total amount you pay to borrow and increase the time it takes to pay off the loan.

The better outcome is to see if creditors are willing to lower your interest rate or skip charging interest for a period. Provided it won’t impact your credit rating, you can also ask about debt forgiveness and whether the company is willing to forgive a portion of your debt if you can pay off the remainder in one lump sum.

Every company will pitch different solutions, so stick with it and see what you can accomplish that will help you get your debt paid off quickly.

Get Debt-Free Small Business Funding

Debt-free funding is helpful whether you’re already overwhelmed by debt or are trying to make smart financial decisions to ensure your business doesn’t wind up with too much bad debt. Invoice factoring is one example of this. Rather than taking out a loan, your business simply accelerates payment on its B2B invoices by selling them to a factor at a discount. You get cash upfront to cover expenses and grow while the factoring company waits on payment. The balance is cleared as soon as your client pays the factor, so there’s no debt to pay back.

If it sounds like factoring is your ideal solution to avoiding bad debts or getting yours paid off quickly, get a complimentary rate quote from Charter Capital.

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