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What You Need To Know About Good Debt And Bad Debt

By Vahe Tirakyan
| 11/16/2021
6 min read

Building your business from the ground up sometimes means getting into debt. Honestly speaking, that does offer the initial investment needed to launch products and take care of operating expenditures until the business takes off.

Startups such as Airbnb and Uber have leveraged the power of debt to become successful. However, taking loans does not mean that your business’s finances will work in your favor every time. Far too many startups have failed due to debt accumulation and the inability to pay it back on time.

What is the difference between good debt and bad debt?

Good debt is money borrowed by entrepreneurs to pay for items that will contribute to the growth and development of their startups. For example, it could be for a new product launch or to hire more human resources.

On the other hand, bad debts are loans that you have given to employees or stakeholders that you cannot collect any more or the additional debts you need to take to pay back the money you previously owed. Bad debts often occur due to a poor financial management system that can inhibit your business’s growth and even cause its downfall.

How can you avoid bad debt?

The best way to stay away from bad debt is to avoid it in the first place. Here are a few ways to prevent bad debts in your business:

Create a credit application.

Before striking a deal with a customer or a vendor, it is advisable to use a credit application. This can be as short as a one-page document that asks for a customer’s basic information and permission to enquire about their credit situation. A credit application will also allow you to establish legal terms with your customer to protect the vendor if there are payment issues.

Establish and follow collection procedures.

Many small businesses tend to make the mistake of having no payment terms or penalty fees on late payments. This makes customers complacent, leading to delay in payments. Almost one in every six small business invoices are paid late.

As a business owner, you must establish clear payment terms and send invoices immediately after a product has been purchased or shipped. You can also incentivize your customers to make prompt payments.

Stick to your terms.

No matter how essential or loyal a customer is to your business, refrain from serving customers who do not pay their dues on time. Not catering to a customer may lose you some business, but it also minimizes the risk of bad debt accumulation.

What are the effective debt management tips you need to follow as an entrepreneur?

It is essential to manage your financial statements and regularly assess areas of unnecessary spending and expenses that can be cut out without sacrificing the critical elements of your business. The following tips will help you manage your financials effectively:

Analyze your budget regularly.

While analyzing your statements, you may find little costs that add to a major proportion of your monthly budget. No financial data assessment will lead to easy debt accumulation since you will not be aware of where most of your money is going.

Know which source of financing will be appropriate for your business.

As an entrepreneur, it is always preferable to analyze what funding sources will suit your business before investing in capital. For example, large business owners have stable cash flow and debt terms, whereas small business owners may not have full debt terms of payment.

Typically, there are two primary sources of funding available to business owners:

• Debt from family or friends

• Debt from banks and financial institutions

However, new business owners may not be eligible for bank loans or other financial instruments.

Consolidate your debt payments.

Usually, the best way for small businesses to consolidate their debt payments is to combine all their short-term loan payments into a more significant debt payment to preserve the business’s credit score. You should also attempt to negotiate with your creditors to set a more reasonable credit limit if you think your debts are piling up.

Create a contingency plan.

In case of bankruptcy, it can become difficult for entrepreneurs to repay their debts. Therefore, it is always a good idea to have a contingency plan in place. Your plan should include having enough liquid assets that can help you repay huge liabilities.

How can entrepreneurs use debt as an instrument to grow their businesses?

Despite the negative connotations associated with debt, it can help your business grow and expand when managed wisely. Whether you are applying for a short-term debt that needs to be paid off within a year or a long-term debt that matures in more than one year, sometimes it is necessary for business growth.

The following are a few scenarios when acquiring a short-term or long-term debt may not be necessary, but is beneficial for your business’s growth and development:

When you are developing a new product: After analyzing your financial budget, utilizing your budget for new product development can be an excellent use of your debts.

When you do not want to lose control of your business: Although debt has an interest attached to it, it is nevertheless a form of external financing that does not require you to forfeit your ownership.

When you want to take advantage of tax deductibles: Since a business’s interest payments are tax deductible, businesses financed with debt payments generate higher profitability than businesses that finance through equity investment.

To conclude.

Growth plans, financial assessments and debt handling are among the most important aspects of running a business. Professionals can help you improve your situation faster since they are aware of market trends and can analyze your business situation. If you are starting your own business, these tips will help you steer clear of bad debt and get a grip on your business’s finances so you can stop relying on debts.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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