Monday 29th Oct 2018
Debts are an everyday, natural part of running just about any type of business. From the newest startup, to the largest multinational, effectively managing debt is an important part of being successful, and it can have a huge impact on the fortunes of a business. Get it wrong, and a business can rapidly run out of cash. Get it right, and cash will be right there when a business needs it, ready for investment, without having any negative effect. SME financing is hugely important - not many businesses get by without it.
Often, in order to work out whether things are working for the business, people will talk about good debts versus bad debts. There’s no single, universal, rule for what a good debt and a bad debt is, but generally there are indicators. Let’s take a look at them here.
What are bad debts?
Let’s start with what a bad debt is. Firstly, it’s important to note that when someone says ‘bad debts’ in a business context, they could very well be talking about two entirely different things. The term often refers to debts that are actually owed to the business rather than the other way around, and more specifically it means debts that have not yet been paid despite being well past the due date. These debts are bad because it’s money that you should have, but don’t.
When is debt not working for you?
In other contexts, ‘bad debts’ refers to debts that the business owes, which simply aren’t effective. These are the ones we’re talking about here. Bad debts are those that are simply a drain on a business, and the benefit of the cash injection are outweighed by the outgoing expense. If your business has debts that to struggle to repay, or are late with, then these would very likely be bad debts. Less significant bad debts could be failed investments that you’re still paying for, much like making payments on a car that constantly breaks down. It’s important to very carefully plan any financial agreements in order to ensure that they won’t prove to have a negative effect in the future.
What are good debts?
Debts can be good, because they can initiate investment. Where they are manageable, debts are a mechanism of getting more cash into the business, that can be used to grow, and ultimately earn more profit. If used correctly, debts are an indication that a business is doing well and is looking to expand. If a business is looking at taking on a debt, they have a specific purpose for it that will yield results in the future, and there are no issues with financing that debt, then it’s likely that it’s a good one. There are many different examples of this.
What are some examples of good debt?
The purchase of property for instance can very often be an excellent investment, but is in the vast majority of cases funded with debt rather than paid for outright. Similarly, taking out a loan for a piece of equipment that has a value, and allows you to make more money than the loan repayments cost, is a perfectly good and sound debt to have. Invoice finance is an interesting type of ‘debt’ that could be considered good, because it’s specifically designed to combat bad debts that are owed to the business. The invoice finance provider lends you most of the value of an unpaid invoice, and then when the invoice gets paid, the debt is settled. It’s a form of lending, but as you know the money is owed to you, and the cash is more valuable to you there and then rather than 30 or 60 days in the future, it could very well be a wise choice. There are lots of options when it comes to small business financing, which means that thoroughly working out which is best, is really important.
How do taxes affect assets and debt?
Part of effective management of debts and assets is understanding how taxes impact them. This is a complex subject, and one that generally requires specialist knowledge, but it can make a major difference as to whether debts are good or bad. Certain assets are taxed differently, depending on how they’re financed, which means that sometimes it is categorically better to technically have a debt for an asset rather than paying outright for an asset. You should consult a tax adviser to find out more about where this applies.
To conclude, effectively managing debts and assets is about accurate forecasting. Using all of the information available to you at the time, you make a judgement on whether or not a debt is going to prove effective over its lifetime and beyond. This is how businesses are successful.