Bad debt arises when a considerable amount of cash inflow is leveraged for servicing debt rather than reinvesting in your business.
Anytime debt and expenses outpace revenue, your business will fall into trouble. Protect from this by practicing disciplined cash management to ensure that your debt is working for you and not against it.
Good versus Bad Debt is a function of why you need the money and how you plan to use it to make more money. Below are the five most common “good” reasons for securing a business loan:
- Business Expansion: if you are turning down business because you don’t have the capacity, then securing financing for new equipment or extra space may be justified. The requirement is that there must be some measurable benefit that improves the productivity or profitability of your business, or the cost of the loan will exceed the benefit.
- Working Captial: short-term loans can create a cash cushion to get business through some projected lean months. Do this if stabilizing your cash flow protects you from emergency layoffs or panicked price cuts. The key is to repay the loan when the tight cash period ends.
- Prepurchase Inventory: using debt to purchase inventory for the upcoming year is a good move if your prepurchased inventory yields higher profits because you are buying it out of season or at a time when it will be at it’s lowest price.
- Credit Builder: businesses with no credit history taking out a business loan and then repaying it on time will build your credit score and potentially give you access to more substantial loans in the future.
- Golden Opportunity: should an incredible opportunity fall into your lap, a loan can enable you to jump on the opportunity, thereby strengthening your company and making repayment more manageable. The challenge here is you must have the ability to get the loan relatively easy.
None of the above options will exist for you if your business is in desperate shape. You won’t qualify for a loan if you have a record for late payments and your previous three years of cash flow and profitability are erratic. You have many past-due accounts, or your financial ratios are upside down. Having cash reserves in place doesn’t only provide you a safety net against liquidity problems later on; it can help you land an affordable loan when the need arises.
Below are six areas that represent “bad” debt, debt you should not take out:
- Uncertain Purchase: if you can’t afford a new business asset, you must reconsider the purchase. A business profit plan will lay out exactly how you expect a new asset to affect your business and how much it will cost. If you are unsure how the loan terms will align with the new asset’s cash flows, revisit your profit plan until you know you can repay the asset loan through the planned profit improvement.
- Passing Whim: just because something looks like an excellent opportunity doesn’t mean it is. If you’re putting your business at increased risk by taking on thousands of dollars of debt, you better be sure the purchase will yield long-term value for your company. Without the due diligence to back it up, a fleeting opportunity or investment will likely do more harm than good for your company.
- Increase Marketing: yes, you will only get more customers by getting the word out about your business, but you don’t want to borrow money for magazine ads, radio ads, billboards, pay-per-click ads, or the like. Effective marketing doesn’t have to be expensive. You might create something as simple as flyers or do social media marketing. Borrowing money to reach more people is not in your best interest unless you have a proven method that you know will work. Don’t borrow for marketing if you aren’t confident that you can pay off the loan with the increased revenue from the influx of new customers.
- Hire Employees: borrowing money to hire more employees is not wise. Yes, hiring the right employee can help you grow your business. They can help you get more done and produce better quality work. They may even have special skills to benefit your business, yet spending borrowed money on an employee is risky. Few employees ever hit the ground, earning you more money than they cost. Taking out a loan to cover the cost of hiring an employee, unless you are a start-up, rarely works out well for the employer. You are better off bringing on new people incrementally as the cash flow from operations warrants than you are through debt.
- Already Maxed-Out: if you already have difficulty repaying loans and have maxed out your credit, taking on additional debt will likely drive you into default. Even if you can arrange another loan, the lender will demand excessive rates, increasing your cash flow problems.
- Reactive Debt Consolidation: debt consolidation can be helpful, but it can also leave you in an even worse position. You may indeed be able to get a better rate, at least temporarily. The problem lies in continuing to do what you have been doing. A business that has been mismanaged needs first to understand what got you into the financial hole you are in before digging a deeper hole. Too often, consolidating loans to give you space to operate is more a band-aid that masks the underlying problem than a solution. A better approach is to fix the problem through disciplined cash and profit management practices rather than borrowing more money.
Bad debt arises when a considerable amount of cash inflow is leveraged for servicing debt rather than reinvesting in your business. Anytime debt and expenses outpace revenue, your business will fall into trouble. Protect from this by practicing weekly cash management to ensure that your debt is working for you and not against it.