A business owner’s guide to differentiating debt
It’s good to be wary of debt. Truly it is, but to say all debt is bad is an oversimplification and, when it comes to business, it’s simply not true – especially in relation to cash flow.
Good debt costs less than the value you get out of it – this is known as a positive return on investment. E.g. If you take out a loan that totals $15,000 for a business opportunity that increases sales by $30,000, that’s a good investment using good debt.
Bad debt is any debt that costs more than you get out of it. E.g. If you take out a loan that totals $15,000 for a business opportunity that increases sales by $5,000, that’s a bad investment. [NB: We’re not referring to bad debt in the accounting sense, which is accounts receivable that will not be collected for whatever reason.] Bad debt is often taken on to cover sudden expenses or purchase items that quickly lose their value. Good debt can also turn bad if the debtor has no strategy to pay it off.
Ugly debt is bad debt that’s run out of control and into the hands of debt collectors. Obviously, good debt can turn bad and then become ugly – and quickly too. An overdue invoice can quickly spiral out of control to the point of incessant phone calls from debt collectors asking for the original debt and their administrative fees to be covered. The key to quashing ugly debt is addressing bad debt early on.
Ugly debt is stressful. How can you tell if your debt has turned ugly? If it feels out of control, and you don’t know how or when you’re able to pay it off, it’s ugly debt. It may be a single overdue invoice that has been handed to a debt collection agency. Maybe it’s a mess of overheads, staff wages, maxed credit cards and, to top it all off, the ATO is on your case about outstanding PAYG. Whatever the type and size of your debt, take action immediately – ignoring it won’t help.
How to fix ugly debt
It may sound obvious, but creditors just want their money. That means most creditors are willing to set up a payment plan to make your repayments more manageable. Ask your creditor if you can set up a payment plan. If you can foresee difficulties with repayments, ask about this before you begin incurring penalties. Alongside developing a strategy to pay down the ugly debts, ensure your bad debts don’t develop into ugly debts by reviewing them regularly and setting up payment plans if you’re concerned about making repayments on time.
Bad debt can turn ugly quickly if it’s not properly managed. Bad debt is often a quick fix for sudden expenses, taken on without first calculating whether the return will be greater than the cost of the loan. That can make it difficult to pay off, especially if the term of your loan is short. So what’s the best way to avoid bad debt? Calculate the potential value of your debt. Is this debt going to help you make more money than the cost of the loan, or is it just covering a sudden expense? Make sure the value you get from your loan is greater than the cost of your loan, otherwise you’re taking on bad debt.
How to fix bad debt
Regularly reviewing and assessing your finances is a sound strategy to avoid your bad debts turning ugly. If you submit quarterly BAS statements, use that process to review your debt repayments. Before taking on any debt you should know exactly what you’re signing up for. Do you know all the fees, interest rates and charges associated with the loan? How are you going to pay it off? When will you pay it off by? What’s the total amount of the interest repayments?
If you don’t know the true total expense of your debt, you can’t know whether it’s affordable or whether you can pay it off – you can’t tell whether it’s good or bad debt.
Out with the bad (and ugly), in with the good
Debt can be a fantastic positive growth tool for your business. But it has to be used properly. Your financial return needs to be greater than the cost of your loan. So how do you make a calculated and informed decision? How can you be confident the debt you’re taking on is good? You need to ensure the return on investment is positive.
How to calculate return on investment
Return on investment (ROI) = (Gain from loan – cost of loan) / cost of loan. If the opportunity is going to create a positive ROI, the potential gain will be greater than the total cost. It’s worth noting that ROI cannot account for any risk involved, but risk appetite is personal. Before you decide to take on debt in any form, you should calculate the true total cost of your debt or loan, and a conservative value for the opportunity. Ensure you take into account the knock-on costs of any potential delays and associated additional costs. Some growth opportunities require a fast decision and quick funding, but it’s important to ensure you make time to calculate the ROI so you can be confident you’re taking on good debt, not bad debt with a chance of it turning ugly.
Check out our Return On Investment Calculator.
The good and how to check
Start by asking whether you’re taking on debt to increase the value of your business. Then check whether you will make more than the loan will cost. You can even calculate the ROI to check. In calculating the ROI, you need to know the true total cost of the debt/loan you’re taking on. This can be easier said than done. Fortunately, we created a free business loan calculator, which lets you calculate the total cost of a loan. It’s important to know how and when you will be able to pay off your debt – known as an exit strategy. Ensure the windfall from your investment will come in before you’re required to pay off your debt. And as ever, if you’re unsure, seek independent financial advice.
How the good can be great for business
One of the most common causes for a business loan is cash flow management. And one of the most common causes of cash flow issues is slow debtor payments. Many wily business owners also use business loans as leverage for growth. They take out a loan to buy a bulk order of stock ahead of a busy sale period, taking advantage of the economy of scale in the process. While they’re taking on debt, they’ve calculated that it is good debt with a strong return on investment for the business.
How you can leverage a business loan to grow your business
Here’s an example of a how a business loan can help businesses grow. A coffee roaster is waiting for cafes to pay their invoices, but they need money to buy more beans to roast the next batch. If they don’t buy the beans now, they will run out of stock for their peak trading period in a couple of month’s time. Because they know they have $50,000 of revenue coming in over the next two months, they’re comfortable leveraging a business loan to ensure they are fully stocked. So they take out a $20,000 business loan to buy inventory, which will bring in a further $60,000 in revenue. This business owner has cleverly and successfully leveraged good debt to capture $40,000 in sale that otherwise would have been lost to cash flow restrictions.
Start with the ugly, then the bad, then try to be good
If you are currently managing debt, start by addressing the ugly debts and ensure you have a strategy to repay them – ask about repayment plans with your creditors. Then ensure your bad debts don’t turn ugly. Be realistic and if you think you’ll find repayment challenging, be proactive and ask to setup a payment plan ahead of time so you can avoid penalties. Before taking on any debt, ensure the opportunity will net your business a positive return on investment. If the opportunity makes sense, a business loan might be a great tool to help grow your business.