Debt Financing: The Good, the Bad, and the Ugly

In an ideal world, every small business owner would have the $5,000 or $10,000 (or $50,000) they need saved up in the bank, waiting to be used to launch the business, purchase that key piece of equipment, take on another staff member, or upgrade their website. Ideally, the cash is available to help as you work to generate sales revenue and positive cash flow.

For many small business owners, however, these funds are not readily available, as every spare dime may be cycling back into the business in other ways, such as paying the rent or buying inventory.

The Catch-22 of Small Business Finance

In these circumstances, a business owner can feel paralyzed: you need to invest more in the business to take it to the next level but don’t have the funds on hand. Many business owners are also reluctant to borrow money, thinking that all debt is “bad”.

But not all debt is created equal.

There are certainly debt products out there that are riskier and more onerous than others. The key number that you need to pay attention to is the annual interest rate or “APR” – you obviously want this number to be as low as possible. Beware that some lenders now quote interest rates on a monthly or even daily basis so that they can appear low – these rates may not be as good as they seem once you equate them to an annual basis.

Different Types of Debt

Below is a summary of some of the potential characteristics of “Good,” “Bad,” and “Ugly” debt:

Features of Good Debt

• Debt is taken on to specifically fund an investment in the business that will increase its net worth.
• Debt has a low interest rate.
  • A low interest rate for a business loan is one that is typically between 4% and 14% APR. (Do not get confused with mortgage interest rates, which currently hover at or below 4% APR).
  • A low interest rate on a credit card is 0% to 5% (but see the note below about credit card use).
• Borrowing term is matched to investment useful life, so you won’t still be paying off a piece of equipment that became obsolete several years ago.
• Established lender who understands small business needs.
• No penalty for early repayment.

Examples: business loan from WEV; business loan from SBA; business or personal line of credit guaranteed by personal asset with an established lender; equipment or car lease/loan from an established lender.

Features of Bad Debt

• Debt is taken on to fund products or services that do not add value to the business.
• Debt has a moderate to high interest rate (16% to 30% APR).
• Debt term is extremely short or extremely long.
  • Short debt terms can result in very high repayments which can choke up a business’ cash flow.
  • Long debt terms can result in you paying a high amount of interest over the course of the loan.
• Debt provider tries to continuously push more debt products.

Examples: Store credit cards; certain online loan or credit products; some invoice factoring

Features of Ugly Debt

• Debt has a high-interest rate (25% APR and up).
• Debt has a short repayment period (one year or less).
• Debt provider makes “Hard-sell” to take on more products (multiple emails, letters, etc.).
• Repayments may be taken from POS/bank account on a daily basis.

Credit Cards – Good, Bad, Ugly, or All Three?

When used with discipline and care, low- or zero-interest rate credit cards can be a convenient form of debt finance for small business owners in a crunch.

Avoid using credit cards to pay for everyday business expenses unless you KNOW that you can pay off the balance in full at the end of each month and not incur any interest. Only consider using a credit card in this way if you gain additional value from using the card – like accruing air miles if you need to travel a lot for your business. If you choose to use credit cards in this way, practice discipline, discipline, discipline!

Final Word on Debt

Before deciding if you should borrow the money you want to grow your business, you need to ask one key question: Will the projected increase in sales revenue from making that investment (the return) exceed the cost of any borrowing to make that investment?

If you can confidently answer yes, then seek out some “good” debt to move your business forward. And, remember, the best debt is one that has been repaid.

#financialsuccess #financialplanning #financialfreedom #financialresilience #financialempowerment #personalfinance #moneymindset

Author

Nicki Parr

Date

Updated on June 6, 2022