Is There Really Good Debt and Bad Debt?
Posted March 18th, 2020
Is there such a thing as “good debt?” Yes, there is. What is the difference between good debt and bad debt? Good debt helps you grow. Bad debt weighs you down.
For example, meet Kelly, owner of Kelly’s Creations.
Kelly has owned and operated the small manufacturing company for 10 years, ever since her dad retired. Kelly is very proud of her fiscal responsibility. In her early twenties, she had a small mountain of credit card debt, which she has paid off. Now, she pays for EVERYTHING in cash, both in business and in her personal life.
One day a customer comes to Kelly with an order too big to fill with her traditional materials budget. It’s a huge opportunity for her company, but she’ll need a funding source. Kelly thinks she’s a shoo-in for a small business loan. She’s never missed a payment to any of her vendors and she has a solid chunk of reserve cash in her bank account.
But what Kelly doesn’t have is credit history. Since she’s never borrowed before, there is no way for the bank to ensure she’ll be responsible with the debt. She is denied the loan.
Debt is not inherently bad.
As Kelly learned, debt is not inherently bad. We know this is true on some level, because most of us take out a mortgage when we buy a home. We may even take out a loan to buy a new car. We accept these forms of debt as necessities. But when it comes to business, many leaders try to avoid debt like the plague.
It is not the plague, though. Debt can be an important part of your business strategy, if you use it wisely.
Types of debt, good and bad.
There are commonly held beliefs on what constitutes “good debt” versus “bad debt.” Examples of good debt are:
- Mortgage
- Lines of credit
- Small business loans
- Automobile loans
- Student loans
These are loans that either pay for an essential in your life, like a house or vehicle, or represent an investment that will pay you a return. Bad debt, on the other hand, has no chance of generating long-term income and/or pays for something that quickly loses its initial value. Bad debt examples typically include:
- Credit cards
- Payday loans or cash advances
- Automobile loans
Did you notice something odd? Automobile loans is on both lists. That is an important point — automobile loans allow you to purchase an essential life item, but the loan itself does not generate income and the item in question quickly loses its value. (Unless you are buying a classic, like the 1969 Dodge Charger, in which case … drive safely!)
Which brings us to the point: It’s not the debt that is bad or good. It’s how you use it.
Good debt is all in how you use it.
It may be convenient to classify one type of debt as “good” and another as “bad,” but these labels do business owners like you a disservice. They strip you of the power to decide how debt will impact your business.
For example, credit cards are commonly thought of as bad debt. But, if you are a small business using a credit card to purchase supplies and you pay the card off every month, this is actually good debt! You are using the money to leverage your buying power and capacity to grow your business (generating long-term income) and you are building a solid credit history.
Let’s talk about another suspect on the lists above: student loans. Investing in your education is great, except expected median salaries haven’t kept up with the cost of a degree. For example, if you borrow $80,000 to get your bachelor’s but only earn a $70,000 salary afterward, you’ll feel the pinch of those payments when they get added onto the rest of your household debt. The situation is even worse for students who take out loans and do not receive a degree.
Even merchant cash advances, which we talk about at length and warn manufacturing and construction subcontractors away from, are not inherently bad debt. Are they risky? You bet. Do we caution business owners in industries like manufacturing and construction away from them? All day every day. But, plenty of business owners use MCAs effectively. They understand the payment structure and know their cash flow can support it.
See how it gets complicated? The real question is not in whether a source of funds is good or bad, but whether you will use the money in a way that allows the investment to pay for itself through business growth and revenue generation.
The ability to borrow in order to capitalize on big opportunities, like Kelly and her customer’s big order, can be the difference between growth, stagnation, or decline for your company. And here’s a tip: Stagnation is decline you haven’t noticed yet.
So now you know that debt is neutral until you use it. The next question is, how much debt should your company have?
How much debt is too much debt?
Now we come to the crux of the matter: balancing opportunity with debt. How much debt is too much debt? There is no hard and fast answer; it depends on your business’ growth plans, the type of debt and cash flow. You can and should keep an eye on your company’s overall debt, especially as it compares to your total income.
This is something your CPA should be reporting on each month — you do have a CPA, right? If not, read this next: 4 Signs You Need to Hire an Accountant for Your Commercial Construction Business.
The fate of your debt lies in your hands.
Are you worried about Kelly? Don’t be. She found the funding she needs, and has since opened up lines of credit with a few of her suppliers and hired a CPA to help her develop financial strategies that will grow her business. She still pays for most items in cash — old habits die hard.
YOU can learn from Kelly’s mistakes. Debt is not an evil boogeyman lurking in the shadows waiting to destroy your business. Debt, when used correctly, can open doors to new opportunities for your business, help you achieve your goals, and give you the foundation you need to GROW.
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