Understanding how to treat business debt can be an excellent resource to grow your company. However, when utilized poorly, debt can irreparably harm your business. It is important to understand the difference between good and bad business debt and know how you can use it to your advantage.
What is good versus bad business debt?
Creating a plan and working with a professional are two crucial things you can do to ensure you're taking on a healthy level of debt.
Debt is a necessary part of any business journey. By taking loans or seeking financing, you're giving your company the fuel it needs to grow. The key, however, is understanding 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, said financing is a crucial ingredient in the growth of many companies.
"Access to capital," he said, "can be the difference between explosive growth, linear growth and the death of your business."
At the heart of good and bad debt are your aims as a business owner. While it may sound obvious, it's important to only take on debt to accomplish goals, spur your company forward or provide the necessary fuel to build your business. It can be easy to take on debt to accomplish one thing and not have a plan for the rest of the money, for example.
"Debt should be used to extend 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
- 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.
- Cheaper than equity. Debt is a cheaper and less risky form of financing than equity. Because there is no legal obligation to pay dividends to shareholders and investors, they want a higher rate of return. Debt is less risky as there is a legal obligation to pay it and having more debt means you’ll have a lower equity base, giving you a higher after-tax profit rate.
Examples of bad business debt
- Debt you can't pay back. A business acquires bad debt when they can no longer pay back the money that is owed to them. When a debt cannot be collected, it is deemed a worthless debt. When filing their taxable income, businesses deduct their bad debts, either in full or in part.
- Loans to clients or employees. If a business gives a loan out to a vendor or employee and the debt cannot be collected, it becomes a loss. A business should only give loans out if they can fully guarantee that the debt can be paid back, often with interest.
[Interested in getting a loan for your small business? Check out our breakdown of the best small business lenders in 2021.]
What is business debt?
There are two types of debt you can accrue: consumer debt and business debt. Consumer debt is money owed by an individual for personal, familial or household purposes. Commonly 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, they are considered consumer debt.
Business debt, or non-consumer debt, is any debt you take on for your business or LLC. Sometimes there can be a gray area. If you use your personal computer for work, that debt is considered consumer debt. If you have credit card debt from a company expense card, that is considered a business debt. The reason it is so important to know which type of debt you have is that you need to make the specific distinction should you get into a situation where you have to file for bankruptcy.
Why healthy debt isn't a defined amount
The amount of debt that's "healthy" for your business to take on will vary widely depending on your own 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 is the co-founder and CEO of Triplebyte, a hiring platform geared specifically toward software engineers and startups. He said 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," he said. "Bad debt is money you spend without understanding how it impacts your business."
Taggar and Triplebyte explored some loan options but ended up raising funds through an equity round. This kind of financing supports Taggar's point – it was exactly what his business needed, and he had a realistic plan for how to build his business with the capital. Ory also weighed his options but ended up getting funding through venture debt, which is provided by a specialized bank that serves small software as a service company.
"Technology has flattened barriers to entry, and it's easier than ever for new companies to enter a market," he said. "The ability to expand your business ahead of cash flow is critical to growth and can provide a competitive edge itself."
How to create a plan for taking on healthy debt
Creating the right plan for your business may involve speaking with a financial professional or hiring a chief financial officer. If you're not a financial expert but are looking to take on debt to grow your business, these professionals can help you move in the right direction.
"Review [your] financials holistically with a financial professional at the end of each month," Taggar said. He also said it's important to do more than just look into the numbers – by diving into fundamental business metrics, you can assess your business's condition and lay out a realistic financing plan.
Ory said Phone2Action has a CFO and accounting department that helps break down the company's financial situation and ensures they're moving in the right direction. If you don't have the funds or ability to work with a professional, do your best to realistically assess your situation. If you make a solid plan for the capital and properly assess your growth, you can successfully raise funds. Taggar warned 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," Taggar said, "[but] growth slows and you're slow to react, you can be left in a fatal situation."
How to get your business out of bad debt
If your business has taken more debt than you can handle, here are some ways to help you dig yourself out of bad business debt.
- Take inventory. Look at all the debt you've accrued and organize it based on interest rates and monthly payments. By having all this data organized you can prioritize which debt to tackle first.
- Increase your company's sales. You can pay off your company's debt by making more profit. This can be done by creating a customer loyalty program, starting a social media campaign and raising the price of your products.
- 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 you have.
If you've taken on debt that you can no longer pay, it's important to act fast and stop spending money. This is a fairly logical and standard protocol. Both Ory and Taggar said by tightening up and getting financially sound, you can better your position and become less reliant on debt.
"Start cutting costs immediately," Taggar said. "It's a painful process, but the longer you delay it the worse a position you'll be in."
Additional reporting by Sean Peek