Debt is something that weighs heavily on the minds of most entrepreneurs. Some debt may be necessary to launch your enterprise, but taking on too much debt can ultimately sink your business. The important thing to remember is that when you use debt responsibly and strategically to advance your business goals, it can be an effective way to enhance growth and opportunity.
Debt 101: The Basics
Chances are, you’ve had loans and debt. A car loan, student loans for college, a mortgage, and credit card debt that you have not paid off in full all count. The annual percentage rate (APR) charged against the principal amount you borrowed is considered the “cost” of the loan. The APR is what the bank or lender charges every month for letting you borrow funds. Some APRs are very low and have a lesser impact on your repayment amount. Other APRs can be very high —upwards of 20%—and add significant time to a loan repayment schedule.
Good debt is generally considered a worthy investment. Federal student loans for college or job training that can help you launch a career are considered “good debt” because of their tax-deductible low-interest rates.
While auto loans may have a higher interest rate, if you purchase a budget-friendly car (not a BMW or Mercedes) that helps you grow your business, it can be a good debt despite the depreciating value.
Using Good Debt to Your Advantage
Here are two way to look at good debt:
- If your car loan is 6%, will having that asset help you earn at least 6% more than if you didn’t have the car? If you’re confident that the cost of the debt can easily be exceeded by the income you’ll earn, it may be a debt worth having.
- If you look at debt from an accounting perspective, you are “in debt” when what you owe is more than what you have (cash and material assets). When deciding if taking on a business loan is right for your business, look at the total amount you would owe on the loan and compare it to what you already own or have saved.
Successful entrepreneurship means making sure you are only incurring liabilities that will benefit your productivity and your business’s value. Don’t be afraid of increasing your liabilities – just make sure you do your homework to ensure the debt will increase your profitability. This is especially true when determining if it’s the right time to hire employees. Payroll is a debt or liability you’ll have to pay, but in return, you’ll have employees to help you increase business and cash flow.
Examples of Bad Debt
Bad debt is something that is working against growing your business. It’s money you spend every month that isn’t productive. Here are three examples of where bad debt can make an appearance.
- Perhaps your business is seasonal. In the off-season, cash flow dips, and incoming funds are reduced. It’s tempting to rely on credit cards to offer stability and balance during times like this. You assume the balance can be paid off in a few months once business picks up again, so you take on bad debt (with an outrageously high APR) rather than tightening the budget and slashing expenses.
- Are you trying to keep a business model afloat that is no longer competitive in your market? Taking on more debt may seem like a more comfortable solution, but it’s a financial hole you may not recover from. Better to take a hard look at your business plan and do some market research to see if you can reposition for success.
- If you’re encountering early success with your business, it’s tempting to upgrade your lifestyle (trade in the budget-friendly car for a luxury model!) and reap the rewards of success. But remember, a business needs time to mature and develop a consistent cash flow. Give the business breathing room and time. Don’t let overconfidence put you in a position where an economic downturn or industry change will put you in a tough spot.
How to Avoid Bad Debt
The best way to avoid bad debt is to practice sound business practices to help your business grow and thrive. Here are a few:
- Avoid wasteful spending and always look to minimize expenses.
- Hire with a clear purpose and only when you can afford it.
- Never overextend the business – even with “good debt.”
- Have ample cash reserves and back-up plans to weather downtowns.
Staying aware of the difference between good debt and bad debt and how liabilities impact your business shouldn’t cause alarm. If anything, debt should be included in your business’ operating plan and funding options, and you should review it regularly to make sure it’s working productively. When you make wise choices about business loans and debt, you’ll be able to take your entrepreneurial ideas and turn them into a thriving, successful business enterprise.
About the Author | Katie Tejada is a writer, editor and former HR professional. She often covers developments in HR, business, recruiting, real estate, finance and law, but also enjoys writing about travel, interiors and events.