Debt is a four-letter word that can make small business owners want to run in the opposite direction. However, as you’ve probably guessed from the title of this article, debt can have both a good side and a bad side. Figuring out how to err on the side of good debt while minimizing your bad debt can be the key to getting your company on steady financial ground and avoiding serious pitfalls. If you want your business to grow and thrive, chances are you’re going to have to incur debt in one form or another—so let's get the basics of good debt vs bad debt and uncover the smartest way to navigate it!
Let’s start with the positive side of debt. Good debt can be thought of as debt that you take on in order to eventually increase your company’s profits (which, as an entrepreneur, is one of the principal goals of running your own business in the first place). You’ve surely heard the old adage, “It takes money to make money.” This is certainly true when it comes to the type of good debt we’re talking about here, including investment in the essentials for getting your business up and running. (Think things like equipment and inventory.) These good debts are incurred with the goal of eventually creating an influx of income into your business.
So long as you’re earning income at a greater rate than interest is being charged on your debt, you can consider it a good debt with a good return on investment. And even if you do happen to have the assets on hand to pay for the things your company needs to get up and running smoothly, it can be wise to go into a bit of debt rather than deplete your cash resources. An added positive is that maintaining a manageable level of debt (i.e. you are able to make monthly payments without enduring too much financial strain) can also help build your business’ credit history and credit rating in the eyes of lenders like banks and other credit grantors.
Although debt can be a positive thing in terms of starting and growing your company and building credit, it can also have a shadier side. Whereas good debt offers a return on your investment, bad debt will not increase your income. In fact, it can even lead to negative cash flow.
So how does bad debt happen? You can incur bad debt by purchasing items you don’t really need that depreciate in value over time, such as a vehicle. (Learn more about depreciation.) Credit cards are common example of a source of potential bad debt for both individuals and companies, due mainly to high interest rates and a payment schedule that can be challenging to keep up with. If you do take on a credit card for your business, make sure to use it responsibly and only spend what you’ll actually be able to pay back. That way, you’ll not only avoid falling into bad debt, but you’ll actually help build your business’ credit in the process! It’s also worth asking your accountant whether any credit card interest you’ve incurred is tax deductible. (Take a deeper dive into understanding bad debt.)
By now, you hopefully see debt as a as less of a four-letter word and more of a potential tool to help build your business when handled in the right way. It all comes down to sound decision-making.