To loan or not to loan, that’s the usual question hovering over business owners’ mind when faced with the dilemma of whether to get a loan or not to buy new equipments and expand their businesses. Most of us know that getting into debt is not financially healthy, well mostly true for consumer debts but not necessarily for business debts. And not all business debts are good, there are bad business debts as well. But sadly, there are many people or businesses having bad debt than good.
The Good
I think it is fair to say that we can all use a little refresher in what constitutes good debt vs. bad debt. Good debt is debt on assets that are earning income for you at a rate greater than the cost (interest) on the debt. Large businesses use something they call the ‘hurdle rate’ to determine if an investment or a purchase is worthwhile. The hurdle rate is simply the cost of capital. Average hurdle rate is around 8 to 10%, and can go as high as 15%. If the hurdle rate is 15%, then only investments or purchases bringing in more than 15% would be considered “good debt”. From a cash flow perspective, however, you should only take loans for which you can afford the monthly payments. But don’t take something out of your personal earnings or from your own pocket, worse from your own credit card, just to justify that you can afford paying for it. This will not justify the purchase and mixing your personal and business finances is a big no-no. If you are purchasing new equipment for your business, make sure that it will pay for itself with the revenue it produces, so structuring a lease or financing program with manageable monthly payments is a wise usage of good debt.
And the Bad
In contrast to good debt, bad debt doesn’t have an obvious way helping your finances. Bad debt also includes debt you’ve taken on for things your business don’t need and decreases their value fast over time. These are also major business purchases that were bought on impulse, not carefully planned, studied and assessed. Same thing with purchases you can’t or hardly afford. Simply put, it’s something that makes you lose money. Most of these purchases don’t just fail to produce a greater return than the interest expense; they produce no return at all! Some even produce a negative cash flow. Most importantly, bad debt doesn’t help you grow your business.
Your financial success in business and life will largely be determined by your ability to discern between good and bad debt. I have known many business owners who have problems with bad debt, and believe me, it’s miserable. As a business owner you should know your business limitations when it comes to deciding major business moves like getting loans. Always embrace good debt. It will give you the leverage you need to take your business to the next level.
Finally, again, don’t get even uglier by getting into many bad debts. Part II of Managing Business Debts will include how to avoid such bad debt pitfalls and how to carefully examine if you really need to grab a business loan.
Tags: bad credit, bad debt, business loans, good credit, good debt, managing business debts
[...] Mortgage Information wrote an interesting post today onHere’s a quick excerpt To loan or not to loan, that’s the usual question hovering over business owners” mind when faced with the dilemma of whether to get a loan or not to buy new equipments and expand their businesses. Most of us know that getting into debt is not financially healthy, well mostly true for consumer debts but not necessarily for business debts. And not all business debts are good, there are bad business debts as well. But sadly, there are many people or businesses having bad debt than good. The Goo [...]