What is good debt?

In small business, debt is often looked at with negative connotations. Many SME owners associate the concept of debt with extreme caution, sometimes missing out on the opportunity to invest in their business.

Contrary to what many believe, not all debt is bad and incurring debt can sometimes be the difference between your business stagnating or growing.

But what is 'good debt' and how do you use it to your advantage?

Good debt is any debt invested into income-producing assets that will allow your business to increase revenue or create deductions as a result. Purchases of real estate, equipment, resources and other assets are all examples of good debt because they contribute to the overall growth and net profit of the business.

By contrast, bad debt is any debt incurred that will cost you money down the track. For example, if you require a $5,000 loan to meet outstanding expenses for the month, that will be classified as bad debt.

One of the most common accumulators of bad debts is depreciating assets. It's common for business owners to try and preserve their assets, but often it is the small business finances that suffer as a result. These decisions can cost the business more than financially, as often they miss the opportunity to invest their money into a stronger income-producing asset.

However, regardless of how you use your debt, it's essential that you apply for a loan that will match the life of your investment. In the most basic sense there are two types of loans: long-term loans and short-term loans. Long-term loans are best suited to significant purchases such as property, vehicles or major pieces of equipment. In comparison, short-term loans such as bank overdrafts, are better suited to bad debts. Ideally short term loans will be paid off as quickly as possible and will only be used to covers costs should unforeseen circumstances deem it necessary.

With that in mind, the two most important questions you should determine before applying for a loan is: 'will it affect my cash flow and how much do I need?'. Even good debt can have an initial negative impact on your cashflow as your repayments could begin well before you start to reap the rewards of the investment, so review your cash reserve and ensure that your business is adequately positioned to handle the debt first.

Equally important is determining how much money your business needs and how much money your business can afford to repay. If your investments fail to meet revenue expectations it's entirely possible that your good debt will transfer to bad; therefore only borrow what you can afford to repay.

Want to find out more? Check out these useful articles.

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