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What You Need To Know About Good Debt And Bad Debt

By Vahe Tirakyan
| 10/21/2022
9 min read

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

Startups like Airbnb and Uber have leveraged the power of debts 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. This is why it’s important to understand the difference between good debt and bad debt for your business. 

Healthy loan practices make all the difference in the exponential growth or a crippling blow to your business. The good news is that entrepreneurs can avoid making the same mistakes by understanding how to prevent bad debt and manage finances effectively. 

What Is The Difference Between Good Debt And Bad Debt? 

Good debt is referred to as money borrowed by entrepreneurs to pay for items that will contribute to the growth and development of the startup. For example, it could be for a new product launch or to hire more human resources. It is majorly viewed as an important investment in your business that supports its expansion and promotion. 

Good debts for business owners include government-sponsored debt programs that allow startups to borrow money at low interest rates. Other than this, debt seems like a more economical and less risky alternative than equity.

On the other hand, bad debts are loans that you have given to employees or stakeholders you cannot collect anymore. 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.

Moreover, investors are also concerned about how well a company is moving forward in terms of profits. If a company spends a major chunk of their earnings paying off debts, it shows how prudent they have been with the money. 

How Can You Avoid Bad Debt? 

As an entrepreneur, if a debt is working against your business rather than for your business, it is time to take action immediately. 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 1-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 1 in every six small businesses ’ 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. For example, offer a 5% discount if the customer pays within 30 days or charge interest on the outstanding balance. 

Also, make sure to send regular reminders for payments through text, calls, and emails. However, you can only implement your payment terms if you have asked your customers to sign a credit application or an agreement contract before lending them any credit. 

Additionally, consider sending the terms of payment application to your new customers at the start of each year as a reminder. 

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. Over time, customers learn which company does not have a strict policy for payment and use it to their advantage. Not catering to a customer may lose you some business, but it also minimizes the risk of bad debt accumulation.

Similarly, do not serve customers who have exceeded their credit limit. Sure, you can increase the credit limit, but only do that after re-evaluating the creditworthiness of your customer. Supplying customers even after their limit extension is just growing your debt exposure without certainty when your customers will pay you. 

Therefore, if you say you are going to charge interest, make sure your customers are aware of the penalties for non-payment. 

Effective Debt Management Tips You Need To Follow As An Entrepreneur

Financial debts can be scary for entrepreneurs as you never know if you'll be able to repay them on time. As such, 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 

Analyzing your budget is a habit that every entrepreneur should practice regularly. While analyzing your statements, you may find little costs that add to a major proportion of your monthly budget. Additionally, a lack of financial data assessment will lead to easy debt accumulation since you will not be aware of where most of your money is going. 

Financial experts advise outlining all the regular expenses and allocating money in order of necessity. Also, abide by the financial limit you set for yourself to avoid any loans in the first place. 

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 type better before investing in capital. For example, large business owners have a stable cash flow system 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 

Since funding from a family member or friend is the easiest and fastest source of financing, requiring no collateral, it is the preferred funding source for small-scale entrepreneurs.

Debts from banks are called Secured Loans and are usually backed by a major asset such as a car or a house. However, new business owners may not be eligible for bank loans or other financial instruments. So, in this case, they can also pitch their business idea to venture capitalists who invest in companies with long-term growth potential. 

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. 

Consider asking to extend your credit limit and see how they can help you. As long as you can make your negotiated payment, it is a sign of narrowing your debts. 

Document All Your Invoices And Transactions

To prevent non-payments or any chances of a potential dispute over the payments, document each transaction. Include your customer’s name and the price, quantity or the payment terms in the document to keep as a proof of your services in case a customer refuses to pay. 

Create A Contingency Plan

In case of bankruptcy, it can become difficult for entrepreneurs to repay their debt. 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. 

Debt is an unavoidable scenario for an entrepreneur. However, you can manage it effectively to build assets that will grow your income and business. If you fail to make any contingency payments, it could end quite disastrously for your business.

Seek Professional Assistance 

As a business owner, you will probably have a lot of responsibilities to take care of. Especially if your business is in its earlier stages, you might be looking after your employees, sales, customers, and all the financials contributing to the smooth running of your business operations. As such, it will be a good idea for entrepreneurs to take help from an accounting professional who can assess all their finances and debt payments. 

Professionals can also help you improve your situation faster since they are more aware of market trends and can better analyze your business situation. There are plenty of financial agencies, accountants, and counseling services available that can help you manage your debt repayment effectively. 

To Conclude 

While there is a clear definition of what bad debt is, debt can be 'good' and 'healthy' depending on your business's financials. Your debt will only be as good as the growth and profit generated from the investments, which can only be successful with a solid plan. 

Growth plans, financial assessments, and debt handling are among the most important aspects of a business. If you're starting your own business, these tips will help you steer clear of bad debts and help you get a grip on your business’s finances so that you can stop relying on debts.

The information included in this article is general only and should not be taken as financial or legal advice. You should always seek personalized financial or legal advice from a qualified professional about starting a business.

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