Q: What is the difference between good debt and bad debt?

A: Good debt refers to borrowing that can generate long-term benefits and enhance a business’s financial position. In contrast, bad debt refers to borrowing that does not contribute to the growth or profitability of a business and can potentially harm its financial health.

Debt is an essential financial tool that allows businesses to fund operations, invest in growth opportunities and manage cash flow. However, not all debt is created equal. Understanding the distinction between good debt and bad debt is crucial for businesses to make informed borrowing decisions and achieve long-term success.

What is debt?

Debt, in simple terms, is the amount of money that a business owes to external parties, such as banks, lenders or suppliers. It involves borrowing funds with the understanding that they will be repaid over time, typically with an interest rate applied.

What is good debt?

Good debt refers to borrowing that has the potential to generate positive returns and add value to a business. This type of debt is usually associated with investments in assets that appreciate in value or generate income over time. Good debt can be viewed as an investment in the business’s future growth and profitability.

One example of good debt is obtaining a mortgage to purchase a commercial property. By acquiring real estate, a business not only gains a physical asset but also benefits from potential appreciation and the ability to generate rental income. Additionally, investing in technology upgrades, research and development or expanding production capabilities can also be considered good debt if they lead to increased efficiency, innovation, and market competitiveness.

What is bad debt? Why might you want to avoid bad debt?

Bad debt, on the other hand, refers to borrowing that does not contribute to a business’s growth or financial well-being. This type of debt does not generate a positive return and can burden the business with unnecessary interest payments and financial strain. Bad debt often involves borrowing for non-essential expenses or using credit to cover operational costs without a clear path to revenue generation.

For instance, using high-interest rate credit cards to finance daily business expenses or taking out loans for luxury items that do not directly impact the business’s operations would be examples of bad debt. Accumulating bad debt can lead to financial instability, cash flow problems, and hinder a business’s ability to invest in growth opportunities.

What is bad debt in accounting terms?

In accounting terms, ‘bad debt’ refers to an amount that is unlikely to be collected from a debtor. It represents a loss or an expense that arises when a business has provided goods or services on credit but is unable to receive full or partial payment from the customer. Bad debt is considered an uncollectible account receivable and is typically recorded as an expense in the accounting records.

When a business extends credit to its customers, it carries the risk that some of them may fail to pay their outstanding invoices. Various factors can contribute to bad debt, such as customer insolvency, bankruptcy, disputes, or unwillingness to pay. Recognising bad debt as an expense allows the business to reflect the reality of the uncollectible amount and provides a more accurate representation of its financial position.

To account for bad debt, businesses typically follow the allowance method, which involves estimating and setting aside a provision for potential uncollectible accounts. This provision, known as the allowance for doubtful accounts or provision for bad debts, is established based on historical data, industry norms, and the business’s own assessment of credit risk. When an account becomes uncollectible, the business writes it off against the allowance, reducing both the accounts receivable and the allowance for doubtful accounts.

By accounting for bad debt, businesses can better manage their accounts receivable, assess the financial impact of uncollectible amounts, and make informed decisions regarding credit policies and debt collection strategies. It is important for businesses to regularly review and evaluate their accounts receivable aging with tools such as CreditorWatch’s DebtorLogic, to identify potential bad debts and take appropriate measures to minimise their impact on financial performance.

Good vs bad debt – the main differences

The primary differences between good debt and bad debt for businesses lie in the potential returns and impact on financial health. Good debt is typically associated with investments that have the potential to increase revenue, reduce costs or enhance the business’s overall value. It is a strategic use of borrowed funds to fuel growth, expand operations, or improve competitiveness.

Bad debt, on the other hand, represents borrowing that lacks the potential for long-term benefits. It often involves spending on non-essential items, short-term operational needs without a clear revenue generation plan or high-cost financing that eats into profitability. Bad debt can hamper a business’s financial health, limit its ability to seize growth opportunities, and increase the risk of insolvency.

What are some examples of good debt and bad debt?

Examples of good debt for a business include:

• Expansion loans: Borrowing funds to expand operations, open new locations, or enter new markets can be a strategic use of debt. If executed properly, these investments can lead to increased revenue and market share.
• Equipment financing: Taking loans or leases to acquire necessary equipment or machinery can boost productivity and efficiency, enabling the business to meet customer demands and increase profitability.
• Research and development loans: Investing in R&D activities can lead to product innovation, improved offerings, and a competitive edge in the market.

Examples of bad debt for a business include:

• High-interest loans: Taking on loans with exorbitant interest rates can lead to significant financial strain for a business. If the interest expense outweighs the potential benefits or returns from the borrowed funds, it can result in bad debt.
• Over-extended lines of credit: Maxing out lines of credit or continually relying on revolving credit without a clear repayment plan can lead to bad debt. High balances and increasing interest charges can make it difficult for a business to manage its debt and negatively impact its financial stability.
• Financing non-essential or depreciating assets: Borrowing to finance assets that do not generate income or lose value over time can be considered bad debt. For instance, taking out a loan to purchase luxury vehicles or unnecessary equipment that does not contribute to the business’s revenue or profitability can lead to financial difficulties.
• Unsecured personal loans for business purposes: If business owners rely on personal loans without separating personal and business finances, it can lead to bad debt. Mixing personal and business expenses can create confusion, hinder proper financial management, and increase the risk of default.
• Unplanned or speculative investments: Engaging in high-risk or speculative investments without a thorough analysis or clear strategy can result in bad debt. If the investments fail to yield the expected returns or result in losses, the borrowed funds become burdensome and can harm the business’s financial health.
• Uncontrolled credit card usage: Similar to high-interest credit cards, uncontrolled credit card spending without a disciplined approach to repayment can lead to bad debt. Relying on credit cards for daily business expenses or accumulating excessive balances can result in compounding interest charges and hinder the business’s financial stability.