Understanding the Difference Between Good Debt Vs Bad Debt

Difference Between Good and Bad Debt

Growing a business requires capital. There are plenty of ways you can source capital, but taking on debt is one of the simplest and most effective solutions.

While we’re often taught to think of debt negatively, debt isn’t inherently a bad thing. In fact, many businesses use debt very effectively, allowing them to grow and thrive.

However, even if debt is neither good nor bad, it needs to be managed effectively to make sure it has a positive impact on your business. To do that, it’s important to understand the difference between good debt and bad debt.

In this article, we’ll explain the difference, and discuss how you can manage your debts to avoid some of the risks that come with growing your business.

What is Good Debt?

Good debt is a type of debt that allows businesses to grow, build wealth and increase revenue over time. In the simplest sense, good debt provides more value than the cost to the business.

Taking on good debt is a very common tactic for directors looking to grow their business. If you’re looking for ways to finance your business’ growth, you should read our article on debt vs equity financing.

Good debt can be used for a wide range of business purposes, including:

  • Purchasing new equipment and assets
  • Marketing your business
  • Investing in professional advice (e.g. advisers, accountants and lawyers)
  • Hiring and upskilling employees
  • Launching new products and services
  • Maintaining a seasonal business during the off-season

For example, a business could use a bank loan to purchase a piece of equipment. The monthly loan repayment is $5,000. 

The new equipment speeds up production significantly. As a result, the business generates an additional $10,000 in revenue each month. 

Because the loan provides more value than it costs the business, it’s considered a good debt.

While good debt is an excellent tool for growing a business, good debts can become bad debts if you don’t manage your money correctly.

How to Manage Good Debt Effectively

It’s important to remember that debt isn’t inherently good or bad. The way you manage your money is the only thing that separates good debts from bad.

If you’re trying to grow your business, you can use the following tips to ensure your debt is “good” debt:

  • Create a budget for your business and stick to it
  • Establish revenue streams that don’t rely on debt to create value
  • Track any credit that has been extended to customers, as well as their repayments
  • Prioritise making repayments against more expensive forms of debt first (e.g. debts with higher interest rates)
  • Have a plan for repaying your debts in full, even if they actively provide value to the business
  • Maintain a cash reserve that can cover 3-6 months of operating expenses to help avoid short-term debts
  • Consolidate debts where possible to reduce interest rates and fees

The most important thing you can do is to stay on top of your business’ financial position. While this can be challenging for large companies, it’s crucial if you want to avoid mismanaging debts and/or taking on bad debts.

What is Bad Debt?

Bad debt is a type of debt that is burdensome to your business. Bad debts are often high interest, and they typically provide less value to the business than the loan is costing.

Common examples of bad business debt include:

  • Credit you’ve extended to customers (e.g. providing goods in advance) that won’t be repaid
  • Poorly managed business credit cards
  • Using credit to cover day-to-day expenses
  • Purchasing depreciating assets
  • Purchasing new equipment that doesn’t improve the business’ ability to make money

For example, a business is experiencing an extended downturn due to a new competitor in the market.

The director uses the business’ line of credit to pay for day-to-day running costs, such as wages and inventory. Because of the ongoing losses, the director can only make the minimum repayments on the line of credit, and the balance grows steadily.

Taking on additional debt hasn’t improved the business’ short- or long-term position. The new competitor is still a threat, the business is still losing money, and now the director also has to make repayments on a growing line of credit – so it’s considered a bad debt.

Like with personal finances, bad business debt can cause the company to fall into a debt cycle, where you take on new debt to pay existing debts. This cycle can be very difficult to escape.

Many bad debts are simply good debts that have been mismanaged. If this type of debt gets out of hand, you may even find yourself facing creditor demands or insolvency proceedings.

How to Manage Bad Debt Effectively

Bad debts should be dealt with as quickly as possible. Debt spirals can quickly get out of hand, and you may end up facing creditor demands or Liquidation if you can’t manage the situation.

If you’ve identified bad debts, or debts that your business is struggling to maintain, you should do the following immediately:

  • Seek professional advice. Business insolvency is a serious issue. Contact a professional adviser as soon as possible. They will be able to assess the business’ situation, negotiate with creditors and develop a plan for moving forward.
  • Negotiate with creditors. If you’re unable to meet the original repayment terms, you can negotiate with your creditors. You may be able to reduce the total debt amount, extend the loan term, reduce repayments and interest rates, or find a solution that works for you both.
  • Restructure your debt. In some cases, it may be possible to consolidate, refinance or restructure your debt to make repayments more manageable. This will typically involve negotiating with creditors to reach a new agreement.
  • Restructure the business. Struggling businesses may benefit from restructuring. Restructuring a company involves making major changes to cut costs and repay debts. This may include reducing waste, selling assets, and altering business processes to improve productivity. Business restructuring should always be undertaken with the support of a registered adviser.

In the worst case scenario, you may need to explore options like Voluntary Administration or Liquidation. These are the last resort, and you should always seek professional advice before committing to a course of action.

Navigate Good and Bad Debts with Advice from Business Savers!

Debt is an excellent tool for managing and growing your business. When used effectively, debt is simply another way to create wealth and value. When used poorly, debt can threaten the solvency and existence of your business.

If you are struggling to manage your debts properly, or if you are concerned that good debts are turning bad, it’s time to seek advice from Business Savers.

Business Savers are a team of insolvency experts. We deal with a wide range of business debts and provide advice and services that can help you get your business back on track.

Contact us today for more information, or book a confidential consultation with the Business Savers team!

* The content of this page is intended for general information only. It does not constitute professional advice. You should consult an accredited professional for legal and financial advice relating to your circumstances. Business Savers is not liable for any loss or injury caused by the use of the information provided on this website.


Posted on

March 20, 2024