5 Types of Bad Debt that Business Owners Should Avoid

How to distinguish between good debt and bad debt.

When an entrepreneur launches a business or wants to grow their company, they generally have no alternative but to take on debt. Among other things, this may involve investing in equipment, moving to a larger commercial space, automating processes and creating new products.

In general, all of these elements constitute good debt as long as they generate:

• Added value. Thanks to the debt, the company can seize business opportunities and explore new markets, etc.
• Revenue that exceeds the borrowing costs. For example, if you take out a loan for a commercial building, you’ll benefit from revenue that will ultimately offset the loan over time.
• Return on investment. You’re financing projects that will be sustainably successful in the near future.

However, certain kinds of debt can negatively impact your organization’s cash position, cash flow and long-term growth. Therefore, you must avoid them at all costs.

The most common types of bad debt.

In order to avoid incurring bad debt, there are 5 mistakes that business owners should avoid.

Using a high-interest credit card.

Credit cards come with annual interest rates that are much higher than those of commercial loans. If you don’t pay your credit card balance in full each month, you can get into debt very quickly since interest charges will be added to your existing debt.

Or worse, if you use your personal credit card to pay for business-related expenses, you’ll damage your credit rating and your personal finances if you’re unable to meet your payment deadlines.

Using a line of credit to purchase equipment.

When you use a line of credit to purchase equipment, you’ll pay interest over an undetermined period. If you don’t have a clear repayment plan, you could create an imbalance in your company’s finances. Making purchases using a term loan, instalment sales contract or lease financing may be more advantageous. And, most importantly, you won’t impact the working capital required for your day-to-day operations.

Going over budget on renovations.

Renovating a commercial space can be advantageous. You can make changes to suit your tastes, attract more customers and improve your brand perception. However, you should draw up a realistic budget and measure the return on your investment. Cost overruns due to unforeseen circumstances and delays can quickly impact your budget and turn your work site into a nightmare. Furthermore, if you lease your commercial space, you’ll be unable to recover the full value of the completed work if you move out.

Using a personal loan for business needs.

Obtaining a personal loan can sometimes be quicker than securing a commercial loan. However, you should exercise caution when taking out a personal loan since you’ll be responsible for the debt if your business defaults on the loan payments. This will negatively impact both your personal credit rating and solvency. The bank could even attempt to recover the debt using your assets such as your home or savings. In a nutshell, it’s better to separate your personal needs and business needs when taking out loans.

Using a long-term loan to pay current expenses.

Avoid using long-term loans to pay current or operating expenses (invoices, rent, marketing and advertising, accounting fees, etc.). Even if this seems like a good solution, you risk paying interest over several years for expenses that could have been settled promptly. You could get pulled into a vicious cycle of debt. Current expenses should be paid using a short-term loan such as a line of credit.

In conclusion, distinguishing between good and bad debt is important. Incurring debt must be part of a carefully considered business vision that will have positive impacts. If you’re having trouble managing your debt, don’t hesitate to call on one of our Licensed Insolvency Trustees. They can help you find solutions.