Debt, Good or Bad? Understanding and Managing Debt
If you’re in business you’ll know that establishing and growing a business often involves going into debt. That can be a scary thing for any business owner but it’s important to understand that there are two types of debt, good and bad. And then there's managing your debt, do it well and you'll go a long way to running a successful business.
Yes it’s a dry subject but using and managing debt are such important parts of running a successful business. When I speak with business owners the discussions regularly revolve around these subjects. Sometimes it’s while a client is rationalising the pros and cons of borrowing but more often it’s assisting them to sort out existing debt, whether the business is having issues or its that they realise it’s costing them too much or it just doesn't suit their business needs.
So, what is debt. Quite simply it’s a liability or obligation owed to another person or party. For a business owner debt is essentially funds borrowed for your business and the difference between ‘good’ and ‘bad’ debt depends largely on the circumstances in which funds are borrowed. Basically, how is the debt put to use and what is the financial position of the borrower.
Ok so what is good debt. Well it is often necessary for the establishment or growth of a business. Debt is considered good when its invested in purchases or spending that benefit your business. These investments might help by generating income, reducing your costs or growing your business’s value.
Good debt should be financially sustainable and that means that your business cash flow should be able to afford to repay it. The decision to go into or increase debt should be based on your existing cash flow or projected cash flow generated from the investment.
Good debt should help your business to become bigger, stronger and more efficient. For example, taking out a loan to purchase equipment for your business that will expand the products or services you offer and make your business more productive.
And what is bad debt. Well it's basically the use of debt for reasons that don’t bring any benefit or wealth to the business. These include unnecessary purchases or items that will quickly depreciate. Upgrading a car, for example, won’t likely generate any extra income for the business.
Bad debt is also where the business is unable to generate the growth needed to cover the cost of repaying that debt. This could be through the terms and conditions of a loan and the businesses inability to meet repayments either through a high interest rate, unfavourable payment terms, or both, resulting in your business struggling or unable to meet repayments.
Unsustainable debt is bad debt that is detrimental to the businesses financial health. That is usually when the borrowed funds cannot foreseeably be repaid and where it doesn’t contribute to the growth of the business in any way.
Managing your debt is a crucial part of running a successful business. I often speak to business owners who have not focused enough on managing the financial side of their business. This can be due to a lack of understanding of the importance of good financial management, not having the skills or knowledge or not having the time to manage it themselves. Usually it's a combination of all of these. Occasionally it just gets too hard which can result in the “burying the head in the sand” approach to financial management. And just a tip, I've never seen this work.
Regardless of the size of your business, good financial management, particularly when it comes to debt, can be the difference between a successful business and a failed business. Regular reviews, making sure your debt is appropriate and working for your business, are a critical part in managing debt successfully. Remember a business is a dynamic beast, it doesn't often remain static so decisions made today may not always suit next month.
If you don’t have the skills, knowledge or time then you should strongly consider getting professional help. That can mean a bookkeeper, an accountant, a finance broker, a business coach or a combination of all. A word of caution however, engaging professional help doesn’t guarantee success. Make sure any professionals you use suits you and your business so that they act like an extension of your business, a business partner if you like, and they provide maximum benefit to you and your business. A good gauge is do you you feel comfortable talking about all aspects of your business and do you trust their advice and input.
So consider carefully any decision to borrow, and that includes decisions not to borrow, is the debt good or bad. Then regularly review your debt to make sure your business is in the best position to succeed.