When Good Debt Goes Bad
by Danny Brown on February 13th, 2008
Although you might be surprised at the thought, there is such a thing as good debt. Despite the fact that all debt is normally associated with poor credit ratings and possible blacklisting - not to mention the potential loss of your company - you can actually sometimes use debt to your advantage. It just needs to be handled properly, and the best way to do that is to understand what constitutes good debt.
Good Debt
The simplest way to look at good debt is through how positive your company assets are. If you have assets that are making money for you at a higher rate than what the debt actually costs to have these assets, then that’s what is known as good debt. So, for example, you may own a host of properties that you rent out. If it costs you $100,000 per month in maintenance fees, etc, but you’re making $120,000 per month in rent, this is a good debt.
Another example of good debt is anything essential that you need to continue trading, but don’t yet have the capital to pay for it completely without using up all of your existing cash flow. For example, an IT company may need to buy numerous servers to keep its business going and provide the work its clients require. However, they can’t afford to pay for the servers in full, so they have them on a business loan arrangement. Because it’s equipment that’s key to their trade, again it’s classed as good debt, since it’s a means of bringing in revenue.
Bad Debt
This is simpler to work out and understand. Whereas good debt generates positive income, bad debt is where income is still generated, but not at a level that will pay off the debt itself. In fact, it doesn’t even cover the interest on the debt. Bad debt also includes non-essential items that you’ve bought or paid for that your company neither needs nor can afford to have. A good example of this could be a flashy company car when the old one is less than a year old; or a personal assistant for the boss when the work rate doesn’t justify the expense.
The problem with debt is that it’s so easy for good debt to turn bad, which is why you need to fully understand how both sides work, or have a very good accountant who can look after it for you. One way to turn good debt into bad is to over-extend too fast too soon. For example, you have a successful delivery business - expanding into new territories too fast and taking on more staff without a solid foothold in a new area is a way to fall into bad debt.
As long as you can differentiate the two and know how to work good debt to your benefit, it’s a very useful tool to have for your business.