How bad debt can actually be good
Thursday, July 19, 2018/
It’s easy to see why we would avoid debt but when it comes to business, this isn’t always the best way to manage cash flow. Not all debt is created equal; Some good debt can actually help grow your business. Rather than oversimplifying all debt as “bad,” there are a few simple ways to identify which are good, bad, or ugly.
Good debt will generate more money or value than the loan – this is known as a positive return on investment. For example, a $15,000 loan for a business opportunity that increases sales by $30,000 is a worthwhile investment using good debt.
Bad debt costs your business more than you get out of it. For example, if that same $15,000 loan only increases sales by $5,000, it’s a bad investment.
It’s important to note that we’re not referring to bad debt in the accounting sense, which is accounts receivable that will not be collected for whatever reason. The bad debt we’re talking about is often taken on to cover sudden expenses or to purchase items that quickly lose their value. Good debt can also turn bad if the debtor has no strategy to pay it off.
Ugly debt is bad debt that’s run out of control and into the hands of debt collectors. Obviously, good debt can turn bad and then become ugly – and quickly too. An overdue invoice can quickly spiral out of control to the point of incessant phone calls from debt collectors asking for the original debt and their administrative fees to be covered. The key to quashing ugly debt is addressing bad debt early.
If you’re already in debt, the best way to manage it is to work your way backwards starting with the ugly, working through the bad and finally, using good debt to net positive returns.
Ugly debt is stressful. How can you tell if your debt has turned ugly? If it feels out of control, and you don’t know how or when you’ll be able to pay it off, it’s ugly debt. Maybe it’s just one overdue invoice in the hands of a debt collection agency. Maybe it’s a mess of overheads, staff wages, maxed credit cards and, to top it all off, the ATO is on your case about outstanding PAYG. Whatever the type and size of your debt, take action immediately – ignoring any kind of bad debt won’t help.
How to fix ugly debt
It may sound obvious, but creditors just want their money. That means most creditors are willing to set up a payment plan to make your repayments more manageable. Stop bad debt turning ugly by asking your creditor if you can set up a payment plan. If you can foresee difficulties with repayments, ask about this before you begin incurring penalties. Alongside developing a strategy to pay down the ugly debts, ensure your bad debts don’t develop into ugly debts by reviewing them regularly and setting up payment plans if you’re concerned about staying on top of repayments.
Bad debt can turn ugly quickly if it’s not properly managed. Bad debt is often a quick fix for sudden expenses, taken on without first calculating the cost of the loan against the returns. That can make it difficult to pay off, especially if the term of your loan is short.
So what’s the best way to avoid bad debt? Calculate the potential value of your loan before signing on. Will it help you make more money than the original cost, or is it just covering a sudden expense? Make sure the prospected value is greater than the cost of the loan, otherwise you’re taking on bad debt.
How to fix bad debt
Regularly reviewing and assessing your finances is a sound strategy to avoid bad debts turning ugly. Quarterly BAS statements can be a helpful process to review your debt repayments. Before taking on any debt, you should know the details of what you’re signing up for. Do you know all the fees, interest rates and charges associated with the loan? How are you going to pay it off? When will you pay it off by? What’s the total amount of the interest repayments?
If you don’t know the total dollar amount of your debt, you can’t decide on whether it’s affordable or whether you can pay it off. In other words, you can’t tell whether it’s good or bad debt.
Out with the bad (and ugly) in with the good
Debt can be a fantastic positive growth tool for your business. But only if you use it properly. It’s important to go through your books and the loan’s terms and conditions to make an informed decision. That way, you can be confident in securing good debts if the expense offers a higher return.
How to calculate ROI
ROI = (Gain from loan – cost of loan) / cost of loan.
Positive ROIs means that the potential gain from a specific opportunity outweighs the total cost. It’s worth noting that ROI cannot account for any risk involved, but risk appetite is personal and differs from opportunity to opportunity. Managing risk includes calculating the true total cost of the loan and a making a conservative estimated value prior to signing any papers.
Make sure you take into account the knock-on costs of any potential delays and associated additional costs. Some growth opportunities require a fast decision and quick funding, but it’s important to make time to calculate the ROI so you can be confident you’re taking on good debt rather than risk a bad debt that turns ugly.
The Good And How To Check
Start by asking whether you’re taking on debt to increase the value of your business. Then check whether the potential returns are higher than the expenses – you can take it one step further and calculate the ROI to check.
In calculating the ROI, you need to know the true total cost of the debt/loan you’re taking on. Fortunately, you can calculate the true cost easily by using a free business loan calculator.
It’s also crucial to know beforehand how and when you will be able to pay off your debt. This is known as an exit strategy. The windfall from your investment should come in before the deadline to pay off your debt. And as always, if you’re unsure, seek independent financial advice.
How The Good Can Be Great For Business
One of the most common causes for a business loan is cash flow management. And cash flow issues usually comes about from slow debtor payments. Despite that, many wily business owners also use business loans as leverage for growth.
By taking out a loan to buy a bulk order of stock ahead of a busy sale period, they take advantage of the economy of scale to ensure a strong return for the business.
How you can leverage a business loan to grow your business
Still not convinced? Here’s an example of a how a business loan can help businesses grow.
A coffee roaster is waiting for cafes to pay their invoices, but they need money to buy more beans to roast the next batch. If they don’t buy the beans now, they will run out of stock for their peak trading period in a couple of month’s time. Because they know they have $50,000 of revenue coming in over the next two months, they’re comfortable leveraging a business loan of $20,000 to ensure they are fully stocked.
By ensuring their inventory is stocked for the next orders, this business owner has cleverly and successfully leveraged good debt to capture $30,000 in sale that otherwise would have been lost to cash flow restrictions.
Start with the ugly, then the bad, and try to be good
If you are currently managing debt, start with the ugly. Address them head on and make a strategy to repay them. This might mean discussing repayment plans with your creditors. Then ensure your bad debts don’t turn ugly. Be realistic and if you think you’ll find timely repayments challenging, be proactive and set up a payment plan ahead of time to avoid further penalties.
In future, before taking on any debt, ensure the opportunity will net your business a positive return on investment. If the opportunity makes sense, a business loan can be a great tool to help grow your business.