Good Debt vs. Bad Debt for Small Businesses
July 19, 2022 | Last Updated on: September 22, 2022
July 19, 2022 | Last Updated on: September 22, 2022
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Small business owners quickly learn that not all debt is created equal. The way debt affects the long-term financial health of a company depends on the specific types and amounts of debt. In this article, we examine the common types of debt that affect small businesses as well as share some solutions for managing debt.
With all of the financing options available to small business owners, it is challenging to understand all of the long-term financial implications associated with each type of business debt. Business financing is often classified as â€śgood debtâ€ť when it is low-interest debt that is used to increase net assets or net income. Small business financing can be considered good debt when the borrower can manage the monthly payments and benefit financially from the loan. Small business financing can be a great financial tool for small business owners.
The first question on the minds of many new business owners and entrepreneurs is, â€śHow will I fund my dream business?â€ť Thatâ€™s where small business lending options come inâ€”they fund great business ideas. Business financing also comes up throughout the life of a business, after the first couple of years, when a business owner is looking to make a large purchase or is experiencing cash flow fluctuations for any reason. Borrowing money can improve financial situations and benefit a company in several ways.
Small business loans make it possible for leaders to take advantage of great opportunities to make money. Expansion, large purchases, or new business acquisition opportunities are often time-sensitive. With proper funding, business owners can take advantage of a great deal, which will grow the business and increase net worth.
Lenders and investors commonly ask about business credit history. Applications for loans and merger opportunities are evaluated based on the creditworthiness and business credit score of a borrower. New business owners are regularly denied financing opportunities because they lack business credit. When a borrower takes on good debt, making on-time monthly payments and managing positive monthly cash flow, the creditworthiness of the company improves.
Many small business owners donâ€™t realize that part of the payments they make on their business loans qualify for a tax deduction. The interest paid on a loan is tax-deductible and can result in a significant reduction of taxable income. For more information on writing off interest expenses, check with a tax professional or the IRS website.
Understanding that there are benefits to small business financing, itâ€™s important to recognize good debt from bad debt. Common financing that is considered a good debt may include business loans, a home mortgage, or student loan debt. Each of these types of financing increases an individualâ€™s net worth when an asset, like a business or home, is purchased. Student loans increase the borrowerâ€™s long-term earning potential and result in a degree or education, which many individuals consider a personal asset.
A term loan is a popular type of debt where the borrower receives a lump sum of money upfront and agrees to a predetermined repayment schedule. Term loans typically offer more flexible repayment options and lower interest rates than other types of business financing. Interest rates for term loans can be fixed or variable. Fixed interest rates remain the same throughout the life of the loan and variable interest rates fluctuate based on the market rate.
Some term loans are secured, which means that there is collateral held by the lender. Collateral can be a fixed asset, like a building, car, or piece of equipment. Other term loans are unsecured, meaning that there is no collateral held from the borrower. Whether a loan is secured or unsecured, the borrower may still be required to attach a personal guarantee or provide a down payment.
Equipment financing is a helpful financial tool for startup entrepreneurs and seasoned business owners. The funds received through equipment financing can be used to purchase computers, computer software, landscaping equipment, machinery, kitchen appliances, copiers, or any other business equipment. Since the asset acts as collateral on the loan, equipment financing can offer low-interest, flexible financing to interested borrowers. The term of the loan is determined by the useful life of the asset.
SBA loans are a business financing option for small business owners where the funds are partially guaranteed by the U.S. Small Business Administration. Since the government backs up to 80% of these loans, they are low risk for lenders and have better approval rates for borrowers. The funds are issued from an SBA-approved lender and payments are made directly to the lender.
There are several different SBA loan programs depending on the intended use of funds, the creditworthiness of the borrower, and the amount of loan desired. SBA loans are preferred by borrowers that can meet the approval requirements because they offer lower interest payments and longer repayment terms than other lending options.
Some of the more popular loan programs available through the SBA are:
Real estate financing is useful to small business owners that choose to buy an office, retail, or industrial location. This type of financing can be used to purchase land, buildings, and office space, or to fund new construction. Real estate loans offer low-interest rates and flexible terms based on the loan amount, lender, and creditworthiness of the borrower.
Defining â€śbad debtâ€ť is complicated. Any debt that negatively impacts the financial health of a small business can be called bad debt. If a small business owner is making payments on a loan and not receiving any benefit in return, it is probably bad debt. The most common characteristics of bad debts include:
Sometimes small business owners carry bad debt, that started out as good debt. If a small business loan had balloon payments or variable interest rates, the terms of the loan may change over time creating bad debt. Other bad debts come from a lack of better options or changes in business activity. Many personal loans used for business, especially short-term loans with high interest, like payday loans, are bad debts. The debt examples that we list next arenâ€™t bad in and of themselves, but when business owners canâ€™t keep up with payments, they can turn into bad debt fast, because they tend to have high interest rates. Keep in mind that if you do keep up with payments, these options can be very beneficial for your company.
Business credit cards can be a great source of financing for small business owners. Credit cards work on the basis that the borrower is approved for a maximum credit line. Borrowers can then use the card for any purchases up to the limit. Monthly payments of interest and principal are made, although only the portion of the payment that is principal will increase the available credit line again.
Business credit card balances that are paid in full each month can give small business owners access to fast, secure, financing and donâ€™t accrue any interest. However, if the total balance is not paid within the allowed period, the interest begins to add up and can create unmanageable monthly payments. Credit cards that are maxed out, or have most of the credit limit withdrawn, negatively impact the business and personal credit score of the cardholder.
A business line of credit is another type of revolving credit, like a business credit card. This type of business financing can be a great financial tool for small business owners that properly manage the payments and available credit line. Borrowers are initially approved for a maximum line of credit and can draw on the line whenever they need fast funding. Like a credit card, borrowers that use this type of financing only pay interest on the amount of funds that are withdrawn. Interest rates on business lines of credit are typically higher than a term loan or SBA loan but are based on the amount of the credit line, the borrowerâ€™s credit report, and the lender. Showing a good payment history and average available credit with a line of credit can help build better business credit, but failure to manage cash flow can easily lead to bad debt.
A merchant cash advance (MCA) offers small business owners a fast financing option where they receive a lump sum payment upfront and repay the loan with future credit card sales. This is a great financial tool for new business owners that expect to see an increase in sales over the next few years. MCAs are especially helpful to borrowers with bad credit but can be expensive when processing fees are considered.
Understanding the long-term implications of debt is the first step to managing debt but must be followed by the ability to recognize how much debt is a healthy amount for your small business. Once you have a grasp on understanding what a healthy amount of debt is for your business, you can take action to reduce bad debt balances and increase your overall creditworthiness.
The best way to understand what a healthy amount of debt for your small business looks like is to look at the cash flow generated each month. If a loan payment exceeds the borrowerâ€™s ability to cover other expenses, like payroll and inventory, the debt is unhealthy. Another way to determine a safe amount of debt is to calculate the Debt Service Coverage Ratio for your business.
Calculating your DSCR is a great way to understand debt. This simple ratio can give insight into whether the business can afford the current debt payments and how a new payment may affect the business. It is often used by lenders when evaluating the creditworthiness of a potential borrower.
DSCR = Earnings before interest, tax, depreciation, and amortization (EBITDA)/annual loan payments
Hint: Subtract taxes, interest, and loan amortization from monthly income to find monthly EBITDA
If the DSCR is:
Calculating your debt-to-income ratio or DSCR is very helpful when evaluating borrowing power, but it doesnâ€™t distinguish between good and bad debt. If your small business had more bad debt than good debt, consider the following tips for debt management.
Reducing the balance on high-interest credit cards can benefit the borrower because it decreases the amount of used credit and saves cash by paying less interest. To pay down credit card debt, consider making additional payments that exceed the minimum monthly payment or doing a balance transfer to a card that offers low interest rates. Luckily, there are several ways to overcome business credit card debt.
Refinancing a small business loan is another great way to escape bad debt. Consider working with a lender, like Biz2Credit, to refinance higher-interest loans with lower-interest financing options. If you are looking to extend the term of your loan or withdraw cash on home equity, a lender can help you explore those debt consolidation options as well.
In this article, we discussed the differences between good debt and bad debt for small businesses. We also discussed some options for getting away from bad debts. If youâ€™re looking to tip the debt scale from bad to good or you are interested in exploring new financing options, give Biz2Credit a call today. The experts at Biz2Credit were able to help Danny Star get financing through a working capital loan, avoiding some higher interest options and being able to grow his own business into a successful California-based marketing company.
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