In our society, there’s a pervasive myth that any debt is always a “bad debt”. Whenever we talk about taking out a loan, or owing someone money, it’s almost always viewed negatively these days.
But for small businesses, the truth about debt is far less clearly defined. In fact, sometimes, in business, established companies and reputed entrepreneurs take out what economists call a “good debt”. As goes the old adage “it takes money to make money”, which best describes good debt.
In a nutshell, good debt helps you generate income and increases your net worth.
Like taking over some debt to finance your college or professional education which increases your earning potential in future, or to start or buy an existing profitable business, or to invest in real estate, or to invest in stocks, bonds, commodities, futures, precious metals etc., depending on your risk tolerance. All these can be classified as examples of good debt.
In contrast, while sometimes even good debt can prove to be bad (where you end up losing money), certain debts are always bad, which by definition include all debts incurred in purchasing depreciating assets. Some example are cars, credit cards, consumables, vacations, petrol and other goods and services.
When is debt “good”
So the obvious question is when should a business or an entrepreneur use loans or good debt to get ahead.
When it encourages fiscal discipline
While it’s common knowledge that taking loans encourages monetary discipline as the borrower becomes prudent and judicious with spending, the most noteworthy point is this when you want to raise some money for your business – taking on debt is far less expensive than giving up equity from your business forever. So go for a loan instead of diluting your equity.
When the debt is less than the opportunity cost
Always compare the debt you plan to undertake to finance an investment, to the opportunity cost of that investment. If the ROI is higher than the cost of the debt, it’s a good debt, and you should go for it.
When the interest on debt reduces taxable profits
Remember that paying interest on debt reduces your tax burden, which means benefits of lower cost of capital when calculating the return from taking out loans.
Sometimes, debt may not be good or bad, but is simply essential, advisable and practical. One such example is debt consolidation, also knowns as bill consolidation or credit consolidation.
As is clear from the name itself, debt consolidation is a financial strategy, where by multiple bills are merged into a single debt that is paid off by a loan, or through a management program. It is especially effective on high-interest debt such as credit cards by reducing the monthly payment by lowering the interest rate on your bills.
When should you go for a loan?
You should go for a loan only when you can easily afford the repayment. In desperate times, often organisations go in debt which they couldn’t possibly repay. This is a recipe for disaster.
A good barometer to judge this is taking a stock whether you may be in a position to pay off the loan early. You might not choose to do it to take advantage of the interest rates, but theoretically, you may be able to pay off the loan early.
If the answer is yes, then it shows that the debt you garnered was strategic and is helping you grow the business.
A good example of this is what many investors and high net worth individuals do, when faced with a choice of either using their portfolio to carry out a major purchase, or to take out a loan for the same.
If the rate on the loan is less than the rate of return on the portfolio, and they can comfortably make the loan payments, they do the purchase with a loan, and keep their money invested.
(if your answer to any of the following is no, then your debt is most probably bad)
- Will this debt improve your finances in future?
- Can you comfortably afford the monthly payments?
- Can you cope up with the interest rates rise in future?
- Have you shopped around for the best deal possible?
- Do you understand all the terms and conditions of this loan?
- Have you estimated the risk tolerance associated with this debt?
How to make the best use of a good debt?
This brings us to the final question that we want to deal in this article, which is – once you have considered all the above points, and decided to take on a good debt, how to make the best use of it.
Get ahead with a wonderful business opportunity
Every once in a while, you will come across a business opportunity that is just too good to pass – even if you can’t afford the initial set-up costs all by yourself. Examples may be someone selling their business as they are moving overseas, or someone going for a distress sale.
If your due diligence points out that the return on investment in the opportunity far outweighs the cost of the loan you intend to take, then this is one of the best uses of good debt.
But be mindful of looking at multiple offers of loans to get the best deal out there in the market, as well as cross-check the financials of the business you intend to buy.
Finally, remember if you want to get really, really rich, your chances are much better if you start your own company and work for yourself. So, going for a small business loan may be the most important decision you ever made leading to your financial independence.
Increase the working capital of an existing business and expand it
Companies – whether small, medium or large – while waiting for long-term financing or an acquirer, also resort to debt to finance working capital and cover expenses such as utility bills, payroll, rent, and inventory costs. This is known as working capital and helps your business tide over seasonal fluctuations.
A good example of this is the tourism industry. Traditionally the peak season of tourists will always be followed by a lull. But businesses will need to keep the staff on their payroll for the next peak season. A good debt will help provide the working capital for that.
Also, sometimes, businesses may need the capital to expand their operations to take advantage of economy of scale. When business is booming, a good debt can help grow your business even further. This ensures that your profits don’t plateau.
A good example of this is again from the hospitality sector. If you have a 10-room-motel with occupancy above 90 percent all through the year, it makes sense to expand it to 20 rooms by taking on some debt. You will easily recover the money in a season of full operations after the expansion is complete. And in a year or two, you will double your profits.
Get into real estate – both housing and commercial
This is the most obvious, considering real estate prices have almost always shown an upward trend – both housing and commercial. (2008 subprime mortgage crisis was an aberration)
In fact, economist have always argued that there is probably no better debt than a mortgage.
Moreover, there are multiple options to explore if you are using good debt to get into real estate or expand your real estate portfolio.
- Securing a debt against a property in poor condition, then using the money to restore, renovate and convert the property, which in turn is sold in the market at substantial profits. This is a good business to be in, if you are from the construction industry, are a property developer, or have substantial investment properties portfolio.
- In ever-changing real estate markets these days, where buyers stand to gain much on capital gains, if they move quickly and swiftly, a good debt is life-saver. The bargain property once secured can then be sold at huge profits.
- A company can use good debt when changing office spaces or renovating old ones. Or, to quickly snap up a property that it would lose otherwise while waiting for long-term financing. Or to get a purchased property up to standards by significantly renovating it for a traditional commercial mortgage.
Read about when Rikvin Capital helped financed a commercial property in Scotland here.
So while there may be situations when going into debt is not advisable, if you plan right and use loans as a strategic tool for growing a business and realising its potential, debt in most cases is the cheapest financing option among the available alternatives.
Good debt helps you manage finances more effectively, leverage your wealth, expand your business and handle unforeseen emergencies. Examples of good debt are a mortgage, borrowing for education, or to consolidate debt. While these may put you in debt initially, you’ll be better off in the long run for having borrowed the money.
Want to know more about bridge financing? Read our post on everything you need to know about bridge loans here.
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