Good debt vs bad debt - What are the differences?
Debt is an obligation that one entity is under to pay another entity known as the creditor.
No one likes being in debt. And the way the word ‘debt’ is pronounced doesn’t do it any favors either. But what if we told you that debt can be good as well.
Good debt vs bad debt is something that applies to people in their personal life as well as business finance.
This short blog will help you understand from a business accountant’s perspective the difference between both these types of debt, examples of good debt and bad debt, and how to focus on building good debt and avoiding bad debt as much as possible.
Good debt vs bad debt
To put it simply - Is it only costing you money or making you money as well? Ask yourself this one question when you are putting your business under any form of debt and you will be able to figure out whether a debt is good or bad.
The debt to equity ratio can also help in this assessment by showing the proportion of debt relative to equity, which can indicate whether the debt is manageable or potentially risky.
Good debt and bad debt both cost you money. But good debt can be seen as an investment because it helps you earn money over time.
You can then use it to finance and pay off the debt. Bad debt in accounting is when you owe money and it doesn’t get you back anything. It is simply a cost to the company.
Good debt vs bad debt can also be classified based on whether something will bring an increase in monetary value or just be a part of consumption. For example, when you rent out or buy equipment for your factory, it is an asset.
So it falls under good debt with the presumption that over time, it will create enough value in the form of finished goods/products that will help cover the cost or rent of the equipment.
Bad debt on the other hand will just be a liability that your organization has to pay off.
What is considered good debt?
Applying for a line of credit
When a business applies for a line of credit, what it is basically doing is getting the financial support to invest in assets that will build the business. Be it hiring employees, making company expenses for advertising, sales, operations, etc.
The debt you take on by using a credit line is considered a good debt because it is utilized to earn money that can then be used to pay off the credit line.
Interest is tax-deductible
In some categories of debt such as investments, the interest you receive can be deducted from your tax to reduce your taxable income.
When debt helps you build credibility
In the good debt vs bad debt argument, debt that helps you build credibility is also considered as good debt.
For example, when your company applies for loans or uses credit providers to carry out business tasks and pay them back on time, it builds your payment history and credit score.
This in turn improves the financial credibility and reputation of your business which can lead to the eligibility of even better loans or credit.
When debt is cheaper than equity
When raising capital for your company, taking debt over equity is almost always the answer. The interest you pay on debt is tax-deductible and it is also lower than the returns you have to give to equity shareholders.
What is considered bad debt?
Taking corporate loans that you can’t back
When a business takes a loan, they do so with the intent of growing their business. But when the business does not show positive results, companies fall into bad debt.
Bad debt loans are those that your business can’t pay back on time and/or has a high-interest rate that is costing you more money than you’re making.
Unable to pay your employees
Hiring employees is a form of taking on debt as you must pay them for their time and services at your company.
When a business is not able to pay its employees on time, and they leave due to this, the company still owes them the remaining salary, while not generating any work from them. This leads to bad debt.
Return on investment is bad in your business
There will also be instances in your business where you think you’re investing by buying or renting something that will eventually pay off dividends, but doesn’t end up giving you the results you were looking for.
For example, if your company decides to invest in media buying and a lot of ads across channels. It is an investment in advertising with the hope of gaining more business within a particular period. But it turns out that the advertising expense was more than the business that you created from it.
In this case, you have a negative ROI and it becomes a bad debt.
Working capital is negative
Working capital is a part of your day-to-day business expenses and needs to be liquid.
No matter how many long-term assets or investments you’ve made, if you don’t have enough working capital to sustain daily processes, the investments you have made will end up becoming bad debt.
Inventory items sitting idle for a long time
If you’ve bought up a lot of inventory and it is just stored away without being converted into revenue, then it turns into bad debt.
Unless and until you can start selling the products, you won’t be able to recover the money you invested in your inventory.
Credit card APR
When you’re not able to pay your business credit card bills in full, you are charged an APR (annual percentage rate) which is an interest on the part payments you make.
This puts you in credit card debt as you’re paying more than what you borrowed and not getting any returns on it.
How to focus on good debt and avoid bad debt for businesses?
1. Focusing on good debt
Choosing good debt vs bad debt requires any business to have a shift in its mentality. The way you approach taking on debt, what value it brings to your company, and how long does it take to recover the cost will all determine whether a debt is good or bad.
For example, using a charge card for your business is a type of debt that can be good debt or bad debt.
If your business can pay back the charge card issuer in full each month the money that is borrowed for expenses, then it is considered good debt the financial tool (charge card) allows you to make a business decision that can lead to further growth for the company and you end up paying the full amount at the end of the month without any hassle.
On the other hand, if you make a purchase through a charge card and are not able to pay the borrowed amount in full at the end of the month, you will be charged a penalty that will cost you a lot. In this scenario, using the charge card becomes a type of bad debt.
Good debt is obtained when you make wise business decisions through forecasting and planning.
2. Beware of the amount of money you are borrowing
Not just how much you borrow, but also how you spend. Similar to the example above, when you use a credit card, it is a wise decision to not use the entire credit limit that is given to you.
Your credit utilization rate can affect your credit score this in turn will affect your future eligibility for loans with a lower interest rate.
The better your credit score is, the better your chances are of getting a higher amount loan with low-interest rates.
You must use your judgment to make smart debt decisions taking into consideration how they will affect your business in the future.
The magic question to remember is simply costing me money or will it help me add value and make more money in the future as well?
3. Avoiding bad debt
Just as taking on good debt requires foresight, avoiding bad debt also needs wise judgment.
Before taking on any kind of debt, you should see whether you have the financial stability to pay it off even if things don’t work out.
A safety net of reserve capital is something your business should have to reduce the impact of bad debt.
Furthermore, your company should always make it a priority to pay off debts as quickly as possible to avoid interest charges, late payment fees, etc.
Choosing the right debt for your company
Making the right decision when taking on debt can be tough. But if you remember these two things, then it will guide your company in choosing the right type of debt and maintaining a good debt ratio:
• Type - The four major types of debt include secured, unsecured, revolving, and installments. While some of them overlap to some degree, keeping in mind the type of debt you take on will help you understand the risk vs the reward for utilizing them.
• Purpose - Why do you need to borrow the money? Or do you even need to borrow this money for your company? Identifying the reason behind why you are taking on debt will help you make smarter decisions.