What is good debt vs. bad debt for a small business?
Learn the difference between debt that helps your business — and debt that hurts. Presented by Chase for Business.
- "Good debt” helps you grow and expand your business by generating cash returns that exceed cost of repayment, while “bad debt” doesn’t generate any future value or cash flow.
- A combination of quantitative metrics, like cash flow and ratios, and qualitative judgments about your business goals and financial tolerance can help you evaluate your current debt and decide whether you’re prepared to take on more.
- A structured plan of action that improves cash flow, consolidates or refinances loans and proactively monitors financial health can help you repay bad debt and stabilize your business financially.
Business debt doesn’t always work against you. The key is to understand whether your next business loan is a stepping stone to future growth or a quick fix that could cause more financial strain on the road ahead. Use this guide to evaluate your current financial health and ensure any debt you’re taking on is purposeful.
What is business debt?
Business debt is money that a company or organization borrows from an outside party and is legally obligated to repay — often with interest. Although borrowing money may sound intimidating, taking on debt can be a strategic way to access the capital your company needs to grow, build good business credit and even benefit from tax advantages. There are plenty of types of business loans to choose from:
- Term loans
- Business lines of credit
- Small Business Administration (SBA) loans
- Equipment financing
- Invoice financing/factoring*
- Commercial real estate loans*
*Chase for Business does not currently offer invoice financing/factoring or commercial real estate loans.
Good vs. bad business debt
When determining good debt vs. bad debt in business, the key differences lie in the purpose of the debt and its return on investment (ROI).
- Good debt is an asset that will generate more cash than what you end up paying back with interest. Aside from a strong expected ROI, it will also have low or reasonable interest rates, and manageable payment terms. For instance, if you run a bakery and take out an equipment loan for an industrial mixer, it will boost your production of baked goods and help to increase your profits.
- Bad debt is often a less proactive and more reactive decision. If you’re not careful, you might find yourself taking on bad debt as a result of funding operational shortfalls, overextending cash for unnecessary expenses or covering losses in general. Examples include high-interest credit cards, payday loans or merchant cash advances. For instance, if your business can no longer afford to pay its employees due to uncollected customer invoices, taking out a high-interest loan to help cover operating expenses could appear to be a solution, but would actually be considered bad debt because it won’t generate future value.
Evaluate good vs. bad debt for your business
Since bad debt doesn’t have a universally accepted dollar amount, it can be confusing to decipher whether your debt is helping or hurting your business. Use the following tips and calculations to evaluate your current debt and make objective decisions.
Question the purpose of every loan
Ask yourself: Will this loan work to increase my future net worth, or am I borrowing to cover a past mistake or current shortfall?
Calculate your core financial ratios
- Find your debt-service coverage ratio (DSCR) by dividing your net operating income by your total debt service (principal + interest). A DSCR of less than 1 means your cash flow isn’t strong enough to cover additional debt obligations.
- Calculate your debt-to-equity ratio by dividing your total liabilities by your owners’ equity to see how much of your business is financed by debt versus your own capital. A higher ratio can indicate your business is a higher financial risk because it relies on borrowed funds.
- Determine your interest coverage ratio by dividing your operating income by your interest expense to see how easily your business can handle paying interest. If the ratio is low, your business may struggle to cover interest payments if revenues dip.
Consider the what-ifs?
If sales dip or payments come in late, would your business still cover its debt comfortably? A quick stress test helps reveal how much risk you’re carrying.
Compare your options
Before taking out a loan, weigh all your options and which works best for your business. Does a business consolidation loan work better for your needs? Or SBA financing? In addition to interest rates, it’s important to evaluate fees, repayment schedules and how long it will take you to repay the amount you owe in full.
Tips for getting out of bad business debt
So you’ve determined you have bad debt. Now what? Instead of panicking, try directing your focus toward creating a structured plan of action to repay the debt and stabilize your business’s finances. Start with these helpful tips.
Improve cash flow
- Increase cash: Put pressure on outstanding accounts receivable and try to collect money quicker.
- Cut costs: Challenge every expense and decide whether it’s essential for running your business or a nice-to-have.
Consolidate or refinance your debt
- Debt consolidation: A business consolidation loan, or combining high-interest debts together as a single lower-interest loan, can help simplify payments and reduce the total interest you end up paying over time.
- Debt refinancing: Sometimes it’s possible to exchange an existing loan for one with either lower interest or a longer amortization period to potentially lower your monthly debt payments.
Talk to a banker or financial advisor
A professional can help you evaluate your business’s financial health and help you form a solid repayment plan to prioritize paying off your debts with the least amount of interest.
Avoid bad debt in the future
- Borrow the right amount of money: When you plan for future loans, review your business plan and evaluate how much money is feasible to pay back — not just the maximum amount the lender offers.
- Monitor your financial health: Frequently monitor and calculate your cash flow and profitability to catch any negative trends before they become a problem.
- Proactively communicate: It’s sometimes possible to negotiate better terms with creditors before you miss any payments to avoid accumulating more interest to pay off.
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