Good debt vs bad debt: How to know which is which

For many people, debt can be intimidating to take on, but the reality is that taking on the right kind of debt can allow your business to grow and flourish. So how do you work out what debt makes good business sense? Chris Mercer, Managing Director at MBP Advisors + Accountants, says it's all about looking at the long-term value the debt is likely to add to your business. What is key is comparing the benefits you expect to accrue from the debt (such as being able to make more sales) versus the costs of the debt (such as interest and fees), and making sure the former is larger than the latter. “As long as you're taking on the debt to make purchases that are going to drive productivity and performance in your business, then there's generally nothing wrong with debt,” he says. Taking on debt can also help you overcome any unexpected short-term cash flow issues you may be facing, adds chartered accountant Stuart Ruddell, Director at JBM & Associates Limited. “If you have ever run a stock business, you will understand the short-term cash flow issues businesses often face. Partnering with a finance provider can provide relief to stop any stock outs or get you access to the bulk deal of your fastest-selling product,” Ruddell adds.

What is good debt?

In essence, Mercer says, good debt allows a business to leverage capital they wouldn't otherwise have access to in order to increase their returns. “Good debt is debt that's going to help your business step up to the next level – it can be for buying a big piece of kit, getting delivery vehicles or even debt to help with advertising and marketing,” he says. “As long as you've got a return on that debt (bigger than the costs) then it's generally going to be a good debt.” For Auckland-based skin wound and scar management clinic owner, Francis Swart, taking out a small business loan to purchase a new salon, renovate the premises and hire a business coach was considered by Swart as a good debt. “The premises were quite old and dilapidated. I needed to freshen them up and make it a beautiful space where people wanted to come, where it’s nice, cosy and inviting,” says Swart, the owner of Gorgeous You. “I’ve met with a business coach, and we are busy sorting out goals and how I’m going to grow my business in the next 12 months.” Ruddell adds that good debt can also be used to increase a business's working capital and smooth out cash flow issues over tough or quiet periods, such as the summer holidays for service-based businesses. “For most people, Christmas is one of the best times of the year. Unfortunately, as everyone else is enjoying their time, it often turns into the worst business period of the year,” Ruddell says. “People pay you late, sales can drop and suppliers want to be paid.”

What is bad debt?

Bad debt, on the other hand, is generally something that costs you more than what you get out of it. “So it's either not going to drive sales, it's not going to improve your bottom line or it's not going to improve the overall value or productivity of your business,” Mercer says. For example, under certain circumstances, a new company car could be a bad debt, he says. “If borrowing money to buy that vehicle is going to lead to you being able to do more work for more people in more places, or it's a vehicle that you need to have in order to deliver your product, then that's a value-adding vehicle,” Mercer says. “But if it's just a vehicle that you're buying for the sake of having a flash new company car, and it's not really adding any direct value to the business, that's a bad debt.”

How to determine good debt vs bad debt

When it comes to determining whether the business finance you're considering will be a good debt or a bad debt, Mercer says it's important that you crunch the numbers. He recommends you ask yourself the following questions:

• How much money can I make from the funds I borrow? What’s the opportunity?
• How much interest and costs will I have to pay for the debt?
• Will I be in a positive financial position in the long run?
• How long will it take me to reach that positive position?
• Can the money be used elsewhere for a better return within a shorter time?
• Am I spending beyond my means?

Ruddell adds that you should also consider the opportunities that extra funding can provide, and whether those opportunities will result in a net benefit for your business. “When investing, you need to understand the return you’re getting on your money. Maybe upgrading your website or your shop can attract more customers, or a new piece of equipment can provide you a whole new service line and revenue stream,” says Ruddell. “The main thing is you budget the return, the repayment schedule and your capability.” If you're still unsure of whether finance will end up being a good debt or bad debt for your business, speak to me or your accountant.