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8 mins read

Good debt vs bad debt: What is the difference?

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.
good vs bad

How can you avoid getting into bad debt and instead focus on good debt?

To avoid getting into bad debt and instead focus on good debt, businesses can adopt several strategies including:

  • Develop a solid financial plan: Create a comprehensive financial plan that outlines the business’s goals, projected income, expenses, and cash flow. This plan will help determine the necessary borrowing needs and identify areas where debt can be used strategically.
  • Conduct thorough cost-benefit analysis: Before taking on any debt, carefully evaluate the potential returns and benefits of the investment. Assess how the borrowed funds will contribute to the growth, profitability, or efficiency of the business. A cost-benefit analysis will help determine if the debt is likely to be good or bad for the business.
  • Maintain a healthy credit profile: Build and maintain a positive credit history by making timely payments on existing debts, maintaining low credit utilisation ratios, and managing credit responsibly. A strong credit profile will increase the chances of obtaining favourable terms and interest rates when borrowing.
  • Seek low-interest borrowing options: Explore different lenders and financing options to find the most favourable interest rates and terms. Compare offers from banks, credit unions and non-bank lenders to secure loans with lower interest rates, reducing the cost of borrowing.
  • Establish a debt repayment plan: Before taking on any debt, develop a clear repayment plan that aligns with the business’s cash flow and revenue generation. Ensure that the business has sufficient income to comfortably make loan payments without putting strain on its finances.
  • Monitor and manage cash flow: Maintain a vigilant approach to monitoring and managing cash flow to ensure that the business has sufficient funds to cover operating expenses, debt obligations, and unexpected contingencies. Implement effective cash flow management practices, such as regular cash flow forecasting and expense control, to minimise the need for excessive borrowing.
  • Implement strong credit control policies: Establish rigorous credit control policies and procedures to assess customer creditworthiness before extending credit. Conduct credit checks, set appropriate credit limits, and closely monitor accounts receivable to minimise the risk of delinquent or bad debts.
  • Regularly review and assess debt: Periodically review existing debts to evaluate their impact on the business and reassess their alignment with the business’s goals. Consider refinancing options if it can lead to better terms or lower interest rates.
  • Seek professional advice: When navigating debt decisions, consider consulting with financial advisors or accountants who can provide guidance based on the business’s specific circumstances. Their expertise can help identify opportunities for good debt and avoid potential pitfalls of bad debt.

What are some ways to manage your debt well?

Managing debt effectively is crucial for maintaining the financial health of a business. Here are some ways businesses can manage their debt well:

  • Create a debt management plan: Develop a comprehensive plan that outlines the business’s current debt obligations, repayment schedules, interest rates, and total outstanding balances. This plan will provide a clear overview of the debt landscape and serve as a roadmap for debt management. Regularly review the plan and make adjustments as needed. Keep track of progress, reassess goals, and adapt strategies to changing circumstances or new opportunities for debt management.
  • Prioritise debt payments: Prioritise debt payments based on factors such as interest rates, penalties for late payments, and the impact on the business’s cash flow. Allocate available funds to pay off debts with the highest interest rates or those that carry the most severe consequences for non-payment.
  • Make timely payments: Ensure that all debt payments are made on time to avoid late fees, penalties, and negative impacts on the business’s credit profile. Set up reminders or automatic payments to help maintain consistency in meeting payment deadlines.
  • Negotiate better terms: Explore opportunities to negotiate better terms with lenders or creditors. In some cases, businesses can renegotiate interest rates, payment schedules, or seek more favourable repayment terms. Open communication with lenders can lead to mutually beneficial arrangements.
  • Consolidate or refinance debt: Consider consolidating multiple debts into a single loan or refinancing existing debt to obtain more favourable terms. Consolidation can simplify debt management and potentially lower interest rates, reducing the overall cost of borrowing.
  • Control expenses: Implement strict expense management practices to free up cash flow for debt repayment. Evaluate and trim unnecessary expenses, negotiate better terms with suppliers, and seek cost-saving opportunities without compromising the quality of goods or services.
  • Set up an emergency buffer: Establish an emergency fund to provide a safety net for unexpected expenses or income fluctuations. Having reserve funds can help prevent the need to rely on additional debt during challenging times.

Get in touch

Get in touch today to hear how CreditorWatch can help your business better manage credit risk exposure and monitor customers without breaking the bank.

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Michael Pollack
Head of Content & Communications
Michael joined CreditorWatch as Head of Content and Communications in July 2021. He has more than 20 years’ experience in business journalism, marketing and communications strategy and digital content development. He is passionate about communicating to the business community how CreditorWatch’s product suite can help them grow and protect their companies.
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