Using business debt judiciously can be an excellent way to grow your company. However, when utilized poorly, debt can irreparably harm your organization. Understanding the difference between good and bad business debt is critical to use debt to your business’ advantage.
We’ll explain good vs. bad business debt and share strategies for ensuring a healthy debt level and getting your business out of debt.
What is business debt?
Debt is a necessary part of most business journeys. Businesses use debt to improve cash flow, pay suppliers, run payroll and more. Taking loans or seeking financing can be part of a business growth mindset.
However, business owners must understand debt, healthy loan practices and the difference between financing that can result in explosive growth and the kind that cripples your business.
Jeb Ory, co-founder and CEO of social advocacy platform Phone2Action, agrees that financing is a crucial business growth ingredient that must be approached thoughtfully. “Access to capital,” Ory noted, “can be the difference between explosive growth, linear growth and the death of your business.”
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It’s crucial to understand your debt type. The two types of debt are consumer debt and business debt.
- Consumer debt: Consumer debt is money an individual owes for personal, familial or household purposes. This type of debt includes car loans, credit cards, mortgages and student loans. Because you accrue this debt for personal reasons and not for your company, this type is considered to be consumer debt.
- Business debt: Business debt, or nonconsumer debt, is any debt you take on for your business, such as a limited liability company. Sometimes, there can be a gray area. For example, if you use your personal computer for work, that debt is considered consumer debt. If you have business credit card debt from a company expense card, that is considered business debt.
What is good vs. bad business debt?
A business owner’s goals are at the heart of good and bad debt. Taking on debt can be positive when accomplishing goals, spurring your company forward or providing the necessary fuel to build your business.
“Debt should be used to extend the runway and help businesses make purchases that they couldn’t normally make if it makes them more competitive,” Ory said. “The type and amount of debt should be directly linked to the type of business.”
Examples of good business debt
Good business debt examples include the following:
- Government-sponsored debt programs: The United States has numerous government loan programs that allow small businesses to borrow money at competitive interest rates. The government will deduct the interest on the debt from corporate income taxes. If your business files for bankruptcy, the debt can sometimes be forgiven or reduced.
- Debt is often cheaper than equity: When it comes to debt vs. equity financing, debt can be cheaper and less risky. Because there is no legal obligation to pay dividends to shareholders and investors, they want a higher rate of return. Debt is less risky because you have a legal obligation to pay it. Having more debt means you’ll have a lower equity base, giving you a higher after-tax profit rate.
Examples of bad business debt
Bad business debt examples include the following:
- Debt you can’t pay back: When you take on more debt than you can pay back, it’s a bad business debt.
- Acquired bad debt: A business acquires bad debt when the money it’s owed becomes unrecoverable. When a debt cannot be collected, it is deemed worthless to the creditor. When filing taxable income, businesses deduct their bad debts either in full or in part.
- Loans to clients or employees: If a business gives a loan to a vendor or employee and can’t collect it, it becomes a loss. A business should only give loans if it can guarantee fully that the debt will be paid back, often with interest.
If your company has debt with a variable interest rate, such as business credit card debt, your payments will likely increase due to 2023’s interest rate increases. Even if your debt load isn’t overwhelming, paying down your debt can save you money in interest.
Why healthy debt isn’t a defined amount
A “healthy” debt amount will vary depending on your situation. Instead of reaching for a defined number, view healthy debt as debt tied to specific growth plans and strategies for your business.
Harj Taggar, a group partner for Y Combinator and co-founder of Triplebyte, says having a defined plan is one of the most important aspects of handling debt. “Good debt is tied to something solid with a clear plan for why it’s helpful,” Taggar explained. “Bad debt is money you spend without understanding how it impacts your business.”
Taggar and Triplebyte explored loan options but ended up raising funds through an equity round. This funding infusion was precisely what his business needed and he had a realistic plan for building his business with the capital.
Ory also weighed various financing options but got funding through venture debt via a specialized bank that serves small software-as-a-service companies. “Technology has flattened barriers to entry, and it’s easier than ever for new companies to enter a market,” Ory noted. “The ability to expand your business ahead of cash flow is critical to growth and can provide a competitive edge itself.”
The best accounting software can help business owners manage their debt load, monitor cash flow and track their company’s financial situation.
How to create a plan for taking on healthy debt
Creating the right plan to amass healthy debt for your business may involve speaking with a business accountant or financial professional or hiring a chief financial officer. If you’re not a financial expert but are considering taking on debt to grow your business, an expert finance team can help you move in the right direction.
“Review [your] financials holistically with a financial professional at the end of each month,” Taggar advised. He noted that you shouldn’t just look into the numbers. Instead, dive into fundamental business metrics to assess your business’ condition and lay out a realistic financing plan.
If you don’t have access to ― or a budget for ― financial professionals, do your best to assess your situation realistically, create a solid plan for the capital and assess your growth properly. However, Taggar advised companies to be wary of situations where projected growth doesn’t align with the debt.
“If you took on a level of debt based on growth assumptions that proved to be optimistic [but] growth slows and you’re slow to react, you can be left in a fatal situation,” Taggar warned.
After paying off your debt, consider depositing the money you save monthly into a business savings account. You’ll have a nest egg to pay unexpected expenses upfront.
How to get your business out of bad debt
If your business has taken on more debt than you can handle, here are some ways to dig yourself out of bad business debt:
- Take inventory: Examine the debt you’ve accrued and organize it based on interest rates and monthly payments. By organizing this data, you can prioritize which debt to tackle first.
- Increase your company’s sales: You can pay off your company’s debt by increasing sales and making more profit. Consider building a customer loyalty program, starting a social media marketing campaign and raising prices.
- Refinance high-cost debt: Consider consolidating your debt or refinancing it if you have strong credit. This will give you a lower fixed interest rate and decrease the number of payments. Additionally, combining your debt into a single payment could improve your business credit score.
- Apply for a hardship plan: Many banks and other lenders have hardship plans for when borrowers fall upon tough times ― especially if the hardship stems from outside factors like the pandemic or a natural disaster. Lenders are often willing to work with you to give you a break from making payments, lower monthly payment or lower interest rate until you get back on your feet financially.
- Cut costs: Take the opportunity to cut business costs. Slashing expenses may mean layoffs, closing unprofitable locations, renegotiating vendor contracts, unloading excess inventory or downsizing your office. The extra money can be put toward paying down your debt.
- Renegotiate your debt repayment terms: If you borrowed money from an individual or owe money to vendors, contact the creditor and explain your situation. Ask for better loan repayment terms to avoid defaulting.
- Improve your collections process: You may have customers behind on paying the money they owe you. If this is the case, step up your debt collection process or give them incentives to pay their bill in full immediately.
- Hire a debt restructuring firm: Debt restructuring companies can help you negotiate with creditors and pay off your debt ― sometimes at a fraction of the original amount owed. While they charge a fee, it’s a better alternative to bankruptcy.
- Stop spending money: If you’ve taken on debt you can’t pay, it’s important to act fast and stop spending money. By tightening your belt and getting financially sound, you can better your position and become less reliant on debt. “Start cutting costs immediately,” Taggar advised. “It’s a painful process, but the longer you delay it, the worse a position you’ll be in.”
Jennifer Dublino contributed to this article. Source interviews were conducted for a previous version of this article.