While it’s true that financing is great for accelerating the growth of your business, it’s critical that you approach it properly. When you understand how to properly treat business debt, it’s a great way to grow your company. On the other hand, if used poorly, debt can harm your business. It’s important that you understand the difference between good and bad small business debt and understand how you can use debt to your advantage.
If you have a small business located in or near Cincinnati and need help managing your small business debt, consider contacting Orcutt & Co. They work with a variety of small businesses with their financial needs, such as payroll, tax planning, monthly accounting, and bookkeeping.
What is Small Business Debt?
There are two types of debt:
- Consumer debt: money owed by an individual- including car loans, student loans, mortgages, and credit cards
- Business debt: debt taken on for a business
There are some things that are a gray area. For example, if you use your personal computer for work, it is considered consumer debt. On the other hand, if you have credit card debt on a company expense card, that is business debt.
It is very important to know the type of debt you’re dealing with so that if you ever have to file for bankruptcy, you can separate those debts.
Good vs. Bad Small Business Debt
There are two things you can do to make sure that you only take on a healthy level of debt:
- Create a plan
- Work with a professional
In an ideal world, we would all be able to pay for everything in full, with cash. However, we don’t live in an ideal world, so debt is necessary for any business journey. When you take on loans or seek other forms of financing, your business has access to the funds it requires for growth and expansion.
The key to healthy small business debt is to understand debt, some healthy loan practices, and the difference between taking on debt that will grow your business versus debt that will cripple your business. After all, as we mentioned, financing is a major component in the growth of most businesses.
Your goals as a business owner are at the heart of both good and bad small business debt and while it may sound obvious, you should only take on debt that will help you reach those goals and move your business forward. Unfortunately, it’s too easy to take on debt to accomplish one goal and have zero plans for the rest of the money.
Good Small Business Debt Examples
- Government-backed debt programs: the USA has government-backed loan programs allowing small business owners to borrow money at competitive rates, and the government will deduct the interest from your corporate income taxes. There may be options available to have the debt reduced or even erased in time. Small business loans may be a good option for funding under the U.S. SBA.
- Loans with low interest rates: the lower the interest rate, the less your business has to pay back over time. Make sure you are able to afford the loan and the additional debt generated through interest.
- Debt rather than equity capital: debt is cheaper and has less risk than equity. Since there is no legal obligation to pay dividends to your investors/shareholders, they usually require a higher rate of return. Debt doesn’t have as many risks. Plus, you’re legally obligated to pay it back, meaning you have a lower equity base and a higher after-tax profitability.
Bad Small Business Debt Examples
- Debt you are unable to pay back: if you cannot pay the money back that you owe, that is considered bad small business debt. If a debt can’t be collected, it is considered a worthless debt. When filing taxable income, a business can deduct at least part of their bad debts.
- Loans with high interest rates: high interest rates may make it challenging for your business to pay back the debt. You could end up owing more than the value the loan was worth to your business and end up missing payments. This could lead to poor business credit scores and lower chances of qualifying for more funding. Also, the more money you have to pay back in interest results in more of your company’s money being tied up in the long run.
- Loans to clients/employees: if a business loans money to a vendor or employee and is unable to collect that debt, it becomes a loss. Loans should only be given when there is a guarantee of it being paid back with interest.
Keep in mind that each individual type of debt may have special requirements or obligations that go beyond the base amount and interest rates. Before taking out debt you should thoroughly ask questions and read all documentation to be aware of any obscure features.
Create a Plan for Taking on Healthy Debt
In order to create a plan for taking on healthy debt, you may need to speak with someone in the financial field or hire a chief financial officer for your business. If you want to take on debt to grow your business but are not an expert in finances, a professional can steer you in the right direction.
Review your financials with a professional at the close of every month. You will want to do more than simply look at the numbers- you’ll want to look at fundamental business metrics to assess the financial condition of your business and map out a financing plan that is realistic.
Tips for Getting out of Bad Debt
If you are dealing with more small business debt than you can handle, there are some things you can do to get yourself out of the hole:
- Take inventory
- Increase sales
- Re-finance high-cost debt
If your small business has taken on debt that can’t be paid, you need to act fast and stop spending. By tightening up your spending and getting yourself into a financially sound situation, you can ultimately rely less on debt.
If your small business is located in or near Cincinnati and you need help with your financials, contact Orcutt & Co. They can help you keep your financials organized, as well as handle your payroll, accounting and bookkeeping tasks, and tax prep.