For most people, the word "debt" has negative connotations. However, especially when starting a small business, you don't need to avoid debt altogether. There is "good debt" that is necessary for growth when launching a business, and there is “bad” debt that could have long-term negative consequences for your finances.
Here's the difference between good debt and bad debt, and how to manage your business’s finances to balance the two.
Good debt vs. bad debt: what's the difference?
As Lyle Solomon, principal attorney for Oak View Law Group, puts it, “good debt returns money to your pocket, but bad debt takes money from your pocket.”
“Debt that increases your future net worth is considered good debt, and debt that reduces your future net value is referred to as bad debt,” Solomon added.
Good debt
Kenneth Hearn, fund manager and head of research at SwissOne Capital AG, describes good debt for small businesses as money borrowed to pay for items that will contribute to the growth and development of their business.
“This could be for anything from paying for improvements to meet new safety regulations, or for expanding your human resources team,” he said. “A general rule of ‘good debt’ is debt that is low-interest, or will increase the overall net worth of your business.”
Paying off your good debt shows you have a favorable payment history and can be reflected in your credit score. The more types of debt you can responsibly handle, the better. Therefore, more lenders will allow you to take out future loans.
[Read more: Financing Strategies for Every Stage of Your Business]
Bad debt
When a lender is borrowing money to purchase a depreciating asset that won't go up in value or generate any income, that is commonly considered bad debt. Any loan or borrowed money that potentially can reduce your business’s future net value should be avoided. Some signs of bad debt include high interest rates, fees and strict loan repayment terms.
Examples of bad debt are payday loans and cash advance loans, which are typically described as “predatory loans.”
“These loans ... target people with bad credit or low income with few options to consider,” said Solomon. “[They often] come with exorbitant interest rates and unethical terms.”
Good debt returns money to your pocket, but bad debt takes money from your pocket.
Lyle Solomon, principal attorney for Oak View Law Group
Things to consider when making a 'good debt' investment
When evaluating potentially taking out a loan, small business owners should determine what type of debt they’ll have. If the lender is taking out a loan on an asset that won't depreciate, such as education, real estate or their own business, on favorable terms, it's considered good debt.
“Healthy debt entails borrowing money for investing in items that do not depreciate over time,” said Solomon. “Keep this in mind before borrowing money for your business. Try to use the funds to reduce a loss or catastrophe.”
One strategy small business owners can use when looking to take on good debt is to commit to the lowest interest possible.
“Your interest payments are tax-deductible,” said Hearn. “These tax deductions can, ironically, bring you above the red line into profitability. Interest rates can actually work for you instead of against you if you play your cards right.”
Tips for getting out of bad debt
If a small business owner finds they're struggling to get out from under bad debt, there are some things they can do to get out of it. The first step is to carefully analyze the business’s budget and financial statements.
“Financial management software has come a long way over the past couple of decades, and having proper procedures for data entry and its use from the very start of your business is crucial to managing debt either good or bad,” said Hearn.
For business owners in “bad debt,” Solomon recommended consolidating bad debts into one loan.
“Debt consolidation is an intelligent debt management approach to ensure you’re paying the lowest rates and on the most optimal or flexible terms available,” he told CO—. “Such a move would prove quite beneficial for your business, as you can avoid worries regarding payments.”
Businesses need to make sure that they are actually able to pay off this new consolidated loan; otherwise, it will continue to adversely impact their business credit and finances. But, If used correctly, restructuring or consolidating multiple debts can be a sensible way to manage your small business finances.
[Read more: Restructuring Your Business Debt? Here's What You Need to Know]
CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.
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