Difference between good and bad business debt

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Did you know that most of the world’s businesses are running on debt? On paper, they are not making a profit. But as they grow, their spending power and ability to diversify keeps increasing – and so does the size of the business.

On the other hand, a majority of the businesses that lack fundamental planning in any of the core business aspects run the risk of getting completely devalued and indebted to the point where no one will bail them out, not even an investor who finds the business idea sound or a bank that wishes to give out more loans.

What does that tell us?

There are two types of business debts – good business debts and bad business debts. The dissimilarities between the two might be a handful on paper but it’s only when you look at the bigger picture do you truly understand what it means for a business to be profitable and successful even though it is running on debt.

The whole point of this article is to help you understand these two types of debts so you can make better business decisions before acquiring more capital.

The difference in broad strokes

Good debt means any capital you acquire to spend on assets that will generate more money over the long run.

Bad debt means acquiring capital for a depreciating asset, a useless asset, or simply capital acquired on extremely unfriendly terms (such as high interest rates).

Broadly speaking, both forms of debts are equally debts, as in you have to borrow money in both cases. But if you borrow for a good reason that will improve productivity or revenue in the future then it is a good debt. If you borrow money to save a depreciating asset, for example, it is considered bad debt.

Good debt returns money. Bad debt takes money away. This generally happens over the course of a few months or years.

Good debt

Any debt that will increase the net worth of your business or its profitability in the future is to be considered a good debt.

Perhaps the best way to understand good debt is by the means of analogies.

Here are a few quick examples to better understand good debt.

  • Borrowing money to pay for items that will ultimately contribute to the growth of your business. This includes borrowing money to purchase equipment or machinery.
  • Borrowing money for improvements such as better safety regulations, or assets that improve productivity, are good debts.

Generally, a good debt is any debt that is low-interest and one that adds value to your business by helping it grow, regardless of whether it’s short-term growth or long-term growth.

Paying off good debt increases your chances of getting more good debt and improves your credit score.

Bad debt

Any debt that will not add value or help your business grow is bad. Similarly, let’s have a few examples to better grasp what constitutes a bad debt.

  • Borrowing money to spend on decorative or non-essential assets and improvements is a bad loan.
  • Getting a loan to save or buy a depreciating asset (an asset that is not generating profit or is generating an ever-lower profit) is also a bad loan.
  • Any loan that can potentially reduce the revenue of your business (such as something that increases expense but doesn’t add value) is also a bad loan.

Generally, loans with unrealistically high interest rates, abnormal fees, or strict repayment terms that don’t sound comfortable are to be avoided. These are all bad loans.

Do not spend your hard-earned money on stuff you don’t need. Your business will thank you for it.

Bad loan providers typically target businesses and business owners with a bad credit score or low income, limiting the options they have. Don’t fall for these traps. If something looks like a bad deal or a bad loan, then it most likely is.

Wrapping up

So, what did we learn?

Investing more money in assets that will improve productivity, increase revenue, or won’t depreciate over time is always a good idea. These can be dubbed good loans.

There’s a middle ground here. Sometimes, you will have a basic necessity that requires a loan. Going for a loan that has a high interest rate and strict payment terms might seem like the only way out. So, is this a bad loan or a good loan, given you are spending on something that will boost productivity, or is a basic necessity?

That’s the dilemma. It differs from case to case. Use your best judgment to determine the perfect balance between a good cause and an unfriendly loan.

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