Starting a small business often requires taking on debt. Whether it’s borrowing money to purchase inventory, equipment, or real estate, or using credit cards to cover operating expenses, debt can be a valuable tool for growing and improving a business. However, not all debt is created equal, and it’s important for small business owners to understand the differences between good debt and bad debt.
In this blog post, we’ll explore the key distinctions between the two, as well as provide practical advice on how to make sure you’re making good debt choices and minimizing your company’s bad debt. By the end of this post, you’ll have a better understanding of how to navigate debt in your own business and make informed decisions that support your financial goals.
Bad Debt vs. Good Debt: What’s the Difference?
Debt can be either good or bad depending on the type of debt and how it is used. Good debt is generally an investment that increases the future net value of the business and your future net worth, while bad debt is a liability that can damage the financial health of the business. Let’s take a closer look at what differentiates the two.
Good Debt
Good debt is a type of debt that is used to finance investments that will increase the value of the business. These investments can include things like purchasing inventory or equipment, buying real estate, or financing a new project. The key feature of good debt is that it is an investment in the future of the business.
Good debt can provide numerous benefits to small businesses. One of the key advantages of good debt is that it can increase cash flow by financing investments that generate revenue for the business. For example, taking out small business loans to purchase new equipment or expand a product line can help increase revenue and improve the business’s overall financial health. This increased cash flow can also allow businesses to take advantage of new growth opportunities that may have otherwise been out of reach.
In addition to increased cash flow, good debt investments can provide stability and growth potential for the business. By making strategic investments in the business’s future, such as hiring new employees or investing in new technology, businesses can improve their long-term financial outlook and position themselves for success. Good debt investments can also help businesses weather unexpected financial challenges by providing a cushion of financial stability.
Bad Debt
Bad debt is a type of debt that does not contribute to the growth or financial stability of the business. Instead, it is a liability that reduces the future value of the business. Examples of bad debt include:
- Using credit cards to pay for operating expenses: Over-relying on credit cards to cover day-to-day expenses and only making a minimum balance payment can be a sign of bad debt. High interest rates and fees can quickly add up, leading to financial stress and cash flow problems.
- Taking out a loan with unfavorable terms: Loans with unfavorable repayment terms, or hidden fees can be seen as bad debt investments.
The risks of bad debt include:
- Costs that are higher than the return: while there is a cost to debt, if that cost is higher than the return your business would make in either future sales or future growth this will ultimately cause additional challenges when it comes to paying the debt back, negatively impacting you cash flow, and potentially creating more debt.
- Damage to credit score: Failure to make interest payments on borrowed money can damage the business’s credit score, making it harder to access financing in the future.
- Hampered growth: Bad debt can negatively affect a business’s ability to grow and stay relevant in the marketplace.
Ways To Help Make Sure You’re Making Good Debt Choices
Now that we’ve explored the differences between good debt and bad debt, let’s dive into some practical advice on how to make better debt investments for your business.
1. Understand Your Financial Situation
Before taking on any debt, it’s important to understand your own financial situation. Determine your gross monthly income, current monthly debt payments, and debt-to-income ratio. This will help you determine how much debt you can reasonably afford to take on.
2. Have a Plan for the Funds
It’s important to have a clear plan for how the debt will be used and how it
will benefit the business. Will it increase revenue, improve efficiency, or provide long-term growth potential? Having a clear plan will help you determine if the debt is a good investment. WIthout a proper plan in place, funds will still get used, but will not necessarily provide as much value to the business, if they are used with intent.
3. Look for Favorable Terms and Experience
You don’t have to settle for the first loan offer you receive. There are a variety of factors small businesses should be on the lookout for such as rates, repayment terms, fees (or lack thereof), reputation of the lender, and customer service experience, which matters insofar as feeling comfortable with the information you received prior to funding and also maintaining an open line of communication with the lender during the repayment process.
4. Maintain a Favorable Payment History
Making on-time payments on your debt is crucial to maintaining a good credit score and accessing favorable financing terms in the future. Make sure to budget for your monthly or daily debt payments and prioritize them in your cash flow plan.
Ways To Get Reduce Bad Debt
If your business has already piled up some bad debt, don’t panic. There are steps you can take to get back on track and improve your financial situation.
1. Stop Borrowing More Money
The first step in getting out of bad debt is to stop borrowing more money under similar circumstances. While taking on additional debt may help in the short-term, in the long run this still means a higher overall amount of debt that needs to be paid, in addition to all outstanding accrued interest.
2. Prioritize Debt Repayment
Make a plan to pay off your existing debt as quickly as possible. Focus on paying off the debts with the highest interest rates first, while continuing to make minimum payments on your other debts.
4. Improve Your Cash Flow
Improving your cash flow can help you better manage your debt payments. Consider ways to increase revenue, such as expanding your product offerings or using creative marketing efforts to draw in new clients. You can also look for ways to reduce expenses, such as renegotiating vendor contracts or cutting unnecessary expenses.
Merchant Growth – Financing That Pushes Your Business Forward
Debt can be a valuable tool for growing and improving a small business, but it’s important to understand the differences between good debt and bad debt. By making informed decisions about debt and following practical advice on how to manage it, small business owners can use debt to their advantage and achieve their financial goals.
With Merchant Growth, you can access financing for a variety of business needs, including equipment purchases, inventory financing, working capital ,and more. Our various financing options are designed to help businesses overcome short-term challenges and achieve long-term growth. Apply today!
