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Good debt and bad debt

Interest is a silent killer. Years ago, I was preparing a friend’s tax return and asked him how much student loan interest he had paid last year. He pulled up his account, told me how much interest he’d paid, then said “Wow, I’ve been paying off my student loans for years and I still owe as much as when I started. How did that happen?” He didn’t know that his loan interest kept accumulating as he was making payments. 😔

Interest is just as much of a problem for small businesses. When left unchecked, interest will accumulate faster than you can pay it off. And, it can quickly overwhelm your cash flow and sink your business. But, the problem isn’t necessarily the interest rate itself. Of course, high-interest debt, like credit cards, is worse than low-interest debt, like bank loans. The real problem lies in why you took the debt and what your plan to use it was. Taking debt without a plan to use it and repay it is a recipe for disaster.

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There are three main reasons businesses take debt:

  1. To leverage it – You use the debt to take advantage of a new investment opportunity (for example, new equipment, an expansion, or purchasing a client base). Typically, when leveraging debt, you’d know exactly why you’re taking it, you’d have calculated your return on investment, and you’d have a good idea of how it’ll impact on your cash flow. This is the best kind of debt.
  2. To bridge a cash flow gap – You use the debt to survive a few more weeks until your cash flow is healthy again. Because, sometimes, everything goes wrong at once and you need some cash to keep the business running while you fix the problem. That’s okay, but ‘bridge’ debt can get out of hand quickly and you need to be really honest with yourself about how serious the gap is. Is it really just a gap? Can you rebound? Or, is this the new status quo and you should quit while you’re ahead?
  3. Just because – You take the debt because someone told you to or you think it’ll solve whatever problem your business has. Except, you don’t really have a plan to use it and you’re hoping you’ll be able to repay it. ‘Just because’ debt doesn’t solve the underlying problems in your business. It just extends the inevitable. This is the worst kind of debt.

Make sure you take on additional debt for the right reasons. Debt alone won’t solve your problems. And, thinking it will, only makes things worse.

THIS WEEK’S ACTION ITEM:Don’t count on your credit cards to carry you through the COVID crisis. Credit card debt is a deep hole to dig out of. Do your research before you need credit and proactively find funding with a lower interest rate. For example, develop a relationship with a local banker, find out what information you’ll need for a loan application, and get everything ready, in case there’s a cash crunch.

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Have a good weekend and stay safe!

Michael Eckstein