Building a business from the ground up frequently necessitates taking on debt. To be honest, that covers the initial investment needed to develop products as well as covers overhead costs until the business is up and running.
Many businesses have benefited from debt financing. Taking out loans, on the other hand, does not ensure that your company’s finances will always be in your favor. Too many businesses have failed as a result of debt and the inability to repay it on time.
As an entrepreneur, you must be aware of the distinction between good and bad debt in your company. Otherwise, you risk starting down the wrong path and ending up in financial trouble later.
What is good debt for a small business?
The type of debt that helps businesses grow and develop is good debt. It could be a new loan to fund the launch of a new product or the purchase of necessary raw materials.
A good debt generates more income for a company than the cost of the debt (interest). Major corporations use the hurdle rate to determine whether an investment is worthwhile. The hurdle rate is simply the cost of capital multiplied by a factor of ten. When the hurdle rate is set at 30%, investments that return more than 30% are considered “good debt.” You’d better get a good return if you’re going to use a credit card for “good debt”!
The use of funds to overcome a loss or crisis is an example of good debt. Let’s say an important piece of equipment in your company breaks down. In that case, borrowing money at a low-interest rate to repair the machinery is feasible, as long as the losses avoided are equal to or greater than the loan’s overall cost. This includes the principal, interest, and fees.
In any case, and for whatever reason, good debt indicates that you and your business will be financially sound in the end.
Apart from positive returns, good debt provides coverage for anything you require but cannot afford to pay in full without depleting your cash reserves. However, in terms of cash flow, you should borrow only what you can afford. Check to see if you’ll be able to afford the monthly payments on a new loan. Purchasing business equipment is an excellent example of this type of debt. Because most equipment generates enough revenue to cover its costs, streamlining a lease or financing program with manageable monthly payments is an excellent example of good debt.
There are two factors that determine whether or not a debt is good. First and foremost, it should assist in increasing your company’s net worth. It should also have a low-interest rate. You might be eligible for a low-interest loan if you have a good credit score. However, if your payment history is littered with missed or late payments, your credit score will undoubtedly suffer. If you have a lot of debt, the best thing you can do is pay it off as soon as possible. You can also combine your debts into a single, manageable monthly payment. This will assist you in establishing a good payment history and rebuilding your credit.
What is bad debt for a small business?
Bad debt is debt that will reduce your company’s net worth in the future.
Bad debt generates no more revenue than the interest on the debt. It usually involves credit card debt for items you don’t need and can’t afford. The majority of these items not only fail to produce a higher return than the interest expense, but they also fail to generate any return at all! Some even result in significant business losses. To put it another way, bad debt does not help your business grow.
Loans you made to employees or stakeholders that you can no longer collect on, as well as additional debts you must incur to repay the money you previously owed, are all examples of bad debts. Bad debts are often the result of a poor financial management system, which can stifle your business’s growth or even lead to its demise.
Debt consolidation loans elicit a range of opinions on how “good” or “bad” this type of debt is in terms of financial health.
Debt consolidation is a debt relief and business management strategy that allows borrowers to repay loans at low-interest rates and with the most flexible terms possible. A debt consolidation loan, on the other hand, will not assist in the case of poor business planning or excessive borrowing.
Replacing your debt with a consolidated loan in order to re-enter debt is a poor financial decision. When used correctly, a debt consolidation loan is an excellent way to manage your small business debt.
Last but not least
This is the ultimate question. Will this new debt pay you back more than you put in over time?
Although it appears to be a simple question, it may require some consideration. After calculating principal repayment and interest payments, does the debt still make sense? Consider it a bad debt if it isn’t. If you answered yes, you have good debt. You can invest both your money and your time in it.
Good debt helps to generate revenue, whereas bad debt lowers your company’s net worth. Simply remember to engrave this point in your heart, and you’ll be fine.
Learn more from finance and read Tips For Handling Startup Finances.
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