What is good debt vs. bad debt for a business?

Why do businesses take on debt?

If a business wants to expand, for example they want to buy assets or increase working capital, there are several ways to fund this, the most common being:

1. Waiting until your business generates sufficient cash to fund the expansion,
2. Raising equity from investors and shareholders,
3. Or, applying to borrow money from your bank.

As part of the business's plan for expansion, a well-thought-out growth strategy or business plan may be helpful and could be shared with your business manager and accountant

Another example of why someone would take on business debt is if they're buying an established business or franchise that has a proven business model and financial track record. In this scenario it’s relatively easy for a bank to establish a level of debt that can be supported by the business.

However, it’s not so easy if someone is applying for debt to help fund (along with their own equity/cash) a start-up business. In this case, the strength of the product or service and well-thought through financial projections are important because the business manager must be confident that the business will perform as expected, or better.

What is a healthy amount of business debt to have?

As a general rule, we wouldn’t want business debt to exceed the amount of money shareholders have invested themselves in their business by way of equity. Or, looking at it another way, if you look at the total assets of a business (excluding intangibles such as goodwill), calculate what percentage of these are funded by the shareholder. We would like to see around 40% of business assets funded by shareholders’ equity, which means that bank debt will be an amount less than 40% of the value of the business assets.

In assessing what is a healthy amount of debt for a business to have, we need to make sure that the business can not only afford that debt today, but also if it runs into unforeseen issues. To do this we recast the financials using an assumed long run interest rate and adjust for any key business risks (for example the loss of a major customer) that we have identified to understand the impact on the business’ performance . We don’t want businesses to be borrowing so much that they can’t weather a minor storm.

A way of reducing the financial pressure on a business is to look at the term of the loan. The longer the term, the lower the monthly repayments. However, the cost of interest over a longer term would accumulate more than over a shorter term. There are a lot of factors which need to be assessed in determining the correct time frame a loan should be repaid over. We would generally lend unsecured or secured (GSA) cash flow loans up to a five-year maximum term. For very strong businesses we may be able to go a bit longer than this, for example up to seven years. If, however, the business term loan is backed by property security, then we could lend up to 15 years.

What is leverage and why is it important for businesses?

Leverage is the ratio of how much debt you have to equity in your business. If you have a lot of debt on the balance sheet (as a percentage of total assets) then you're highly leveraged. If you run your business on just equity, then you're not leveraged. Without debt, a business can grow at a certain pace, and many do. Being selective about what debt you take on may allow you to grow your business quicker. For example, taking on debt may allow you to purchase more assets or fund growth that you otherwise would have had to wait until sufficient profits had been generated.

What is good debt?

Debt could be beneficial to a business if it enables increased sales and profits. Some examples could include:

1. Buying assets that could improve the productivity of the business. If a joinery business buys a new wood-cutting machine because the savings on labour costs are higher than the cost of the machine, then that could be a good reason to buy the machine. Similarly, buying your own premises rather than renting could have good long term financial benefits to a business.
2. Overdrafts for working capital needs could also be beneficial. These help to smooth out the need to pay expense items against the speed at which money owed to the business can be collected. Whilst overdrafts carry a higher interest rate when drawn, they can be a very cost-effective form of finance if the amount of debt fluctuates a lot.

What is bad debt?

There are also many reasons why taking on debt could be bad for a business. Some examples of this could be:

1. Taking on debt so you can do more work for someone who isn't guaranteed to pay you would be a bad reason. The same can be said for businesses that do unprofitable work for their customers – they need debt to fund the losses they are making, which is ultimately unsustainable.
2. Using debt to purchase assets for the business that don’t have a good earning capability could also be bad thing. We have seen numerous business owners with tight cashflow, buying themselves the latest car for their own use or a highly specialised machine that isn’t used very often, and then the business struggles.
3. Taking on debt from a small third-tier lender that has high interest rates is also bad debt. We would much rather talk to you about your situation and work out a way forward rather than you going to a third-tier lender.

A good rule is, if you can’t afford it, don’t take it on.