Good vs Bad Debt
Good debt vs bad debtIn Australia, debt is often considered a dirty word. But for many businesses, debt is a healthy way to grow and flourish. Here's how to distinguish good debt from bad debt. One way to think about debt is like fat in a diet. There are types of debt that can make your business healthier, and debt you want to limit. Likewise, used incorrectly and in excess, debt can bloat and hamstring your business. But used wisely, good debt has the potential to boost the health, net worth and income of your business, says accountant and director at Box Advisory Services, Davie Mach. “Debt can be a good thing if you’re able to leverage that debt to make more money in the long run,” says Mach.
What is good debt?In essence, says Mach, good debt can be defined as a sensible investment for the financial future of your business. Essentially, he says, good debt allows a business to leverage capital they didn’t have access to in order to increase their returns. “Good debt is money you borrow that will be used to produce more money,” says Mach. “The money you make from putting debt to good use will be more than the associated interest payments and costs.” Student loans, business loans, motor vehicle loans and mortgages can all be examples of good debt. Mach said, for example, if a planned business expansion was going to require a loan of $150,000 and the total interest and cost per year was 10% ($15,000), and you believe the expansion will deliver you an extra $50,000 profit annually, then this would be considered a good debt.
What is bad debt?On the other hand, says Mach, a bad debt is generally something that costs you more than what you get out of it. “Bad debt is money you borrow that will not give you a higher return in the long run and can reduce your wealth in the long run,” Mach says. “Debt can become bad debt if the funds are not used to generate further income, or the interest rates and cost of the loan are way too high.” For example, Mach explains, let's assume a business borrowed $150,000 at an interest rate of 10% ($15,000) to purchase more equipment, but the new equipment was barely utilised due to the business losing a major contract. “That could be considered a bad debt because the business would likely end up paying the $15,000 in interest without earning an income greater than the cost to service the debt from the use of the equipment,” Mach says.
How to determine good debt vs bad debtWhen it comes to determining whether the business finance you're considering will be a good debt or a bad debt, Mach says it's important that you crunch the numbers. He recommends you ask yourself the following questions:
- How much money can I make from the funds I borrow?
- How much interest and costs will I have to pay for the debt?
- Will I be in a positive financial position in the long run?
- How long will it take me to reach that positive position?
- Can the money be used elsewhere for a better return within a shorter time?
- Am I spending beyond my means?
Seeking adviceIf you're still unsure, Mach says you should speak to a business lender, accountant or broker to help you work it out. “Before borrowing money you need to look at the big picture of the loan,” he says. “It's best to see an expert for some advice before deciding what to do.”
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