Good Or Bad Business Debt?
What Is The Difference?
I was recently asked by a client what debt is good for a small business.
In reality, debt for a business can fall into two camps:
In simple terms, ‘good debt’ is when the debt allows the business to grow and there is a ‘good return on the debt’ while a ‘bad debt’ creates no appreciable growth for the business and ‘no good return on the debt’.
Let me discuss this more fully here.
Determine Whether A Debt Is Good Or Bad By Looking At The Return On The Debt
The best way to determine if a debt is good or bad, is to consider the ‘return on the debt’.
‘Good debt’ is a debt that allows a business to grow and where there is a ‘return on the debt’ after the cost of the debt. If, say, you took out a loan for £20,000 at a low interest rate to buy a vital piece of equipment that would allow you to grow your annual business revenue from £100,000 to £125,000 and at a 25% per annum growth thereafter, you could think that this is a ‘good debt’. And, because this loan is allowing you to grow your business sales by more than you are borrowing and, if the rate of interest is relatively low, and where you can comfortably cover the repayments, you could think that this is a ‘good return on the debt’.
Furthermore, if the loan is to purchase a good piece of equipment that you could use for many years, say up to 10 years, your loan would be allowing you to acquire a good asset that could bolster the value of your balance sheet. This would be deemed to be a particularly valuable asset, especially as the life of the equipment greatly exceeds the loan repayment period and especially if the likely repairs and upgrades to the equipment would be modest in cost.
Such a debt could be considered to be a ‘bad debt, if the expected growth is much lower, say only £5,000 per annum or 5%, the interest rate is higher, and the life of the equipment purchase is relatively short.
A debt could also be deemed to be poor if a new loan is taken out to simply keep a business trading due its poor profitability. Here there is likely to be no sales or profit growth potential from the debt creating a ‘poor return’; this would also be considered to be a ‘bad debt’.
Do Not Borrow More Than 35% Of Annual Sales
As a general rule, I always recommend businesses do not let their borrowings exceed 35% of annual sales, as any higher could put a business under stress through the repayments etc, especially if sales and profits were to drop.
If you already had high borrowings, say in excess of 35% of your annual sales, and, you were considering borrowing more, this could add additional stress to your business.
A debt could at first seem a ‘good debt’ because there is a good return with good growth potential but, because it pushes the total borrowing over 35% of total sales, it really could be classed as a ‘bad debt’. In such a situation, you really should ‘crunch’ your numbers well to ensure the finances stack up.
Using Borrowings Is Better Than Using Cash
Where a new loan is a ‘good debt’ and total borrowings are under 35% of total sales, using debt to grow a business is far wiser than using your cash.
Using borrowings rather than cash is a quicker way generally to grow a business; For example, waiting for profits to accumulate as cash and using the cash to grow a business is a slow process.
By using ‘good debt’, you are also spreading the risk of your business rather than ‘putting all your eggs into one basket’, as you would be using your own cash.
It is always wise to keep a good cash liquidity within your business in the event of ‘emergencies’, such as a recession or a pandemic.
Debt Interest Is Tax Deductible
Interest paid on loans is tax deductible, allowing you to reduce your taxable profits and the amount of tax you pay. If cash is used to buy equipment, for instance, you would not have the same tax benefit.
There is no sense in paying more tax than you need to; that money is more use to you than the government.
Having No Debt Is Often Unwise
For most businesses, having no debt is really unwise.
Provided you keep the ‘good debt’ burden below 35% of sales and you act responsibly, you can achieve far greater growth in shorter periods of time, and you can enjoy lower taxable profits.
Using Debt Responsibly Can Build Your Credibility
If you use ‘good debt’ responsibly to grow your business and you always make interest and capital repayments on time, this can build credibility for you and your business, and this will allow you to make future borrowings more easily and at a lower rate.
For debt, you must ask yourself if the debt is ‘good’ or bad’ by considering the following questions:
What is the growth return potential on the debt?
What is the interest rate charge and other costs of the debt?
Would total borrowings stay within 35% of total sales?
Could the debt can be repaid responsibly?
Is there a tax advantage?
You should think that it is better to use ‘good debt’ rather than cash, as you must retain a good level of cash liquidity within your business.
Having some ‘good debt’ is a good business practice.
Please Contact Me, If You Have Any Comments Or Questions About This Blog Article. I Would Be Pleased To Help You
Robert Viney Is An Award-Winning Business Coach
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