Ok, this blog topic is going to be a heady one, but bear with me. Most small businesses take on debt — either as a startup or during periods of growth. According to the 2021 Report on Employer Firms, “79% of employer firms currently have debt outstanding.” In 2019, only 71% of business owners carried debt. The average business owner owes a lot more than the average consumer: $195,000 and $96,000 respectively.
Your instinct as both a business owner, and in your personal life, might be to balk at the idea of taking on debt. However, not all debt is bad debt. Good debt can help boost your credit score, fund necessary business operations, encourage growth and make your business more desirable to future lenders. In this post, we define the key differences between good and bad debt when running a business. We also explain how to get rid of bad debt that might be negatively impacting your business.
Terms to Know
As a small business owner, you probably have more insight int0 your business’s finances than anyone else. However, boosting one’s financial literacy never hurts. Below are a few terms to know before reading the following post about the difference between good debt and bad debt.
In short, “debt” is borrowed money. Whether you borrow money from a friend, a credit union, an online lender or a traditional financial institution, debt is just borrowing money.
Debt is either secured or unsecured, and then either revolving or installment. The most common types of debt are mortgage or home loans, business loans, personal loans, car loans and credit card debt.
As we will explain in this post, not all debt is bad debt. Whether your debt is good debt vs bad debt depends largely on your approach to debt management.
Confusing liabilities with debt is common because there is an overlap in their definitions. Alongside assets and equity, your business’s liabilities are used as a measure of your business’s financial health.
According to this resource from AccountingTools.com, “the main difference between liability and debt is that liabilities encompass all of one’s financial obligations.” On the other hand, “debt is only those obligations associated with outstanding loans.”
There are current liabilities, contingent liabilities and long-term liabilities. In her article “Business Liabilities Every Owner Should Know” for Business News Daily, Jamie Johnson explains the difference between the three.
The business owner must pay off current liabilities within one year. These include liabilities like interest payable, bank fees, short-term loans, “credit lines, salaries and accounts payable.”
Long-term liabilities are debt obligations that must be paid off “after more than a year.” These include loans with longer terms — like mortgages, commercial real estate loans and certain business loans.
Lastly, contingent liabilities are those that must be paid pending the “outcome of a future event.” A good example of a contingent liability is what your business could owe once a lawsuit has wrapped up.
The difference between secured debt and unsecured debt is whether you had to provide collateral in order to obtain the money borrowed. With secured debt, the lender can repossess an asset you own.
Mortgages and other bank loans are probably the most common examples of secured debt. If you fail to make monthly mortgage payments, the broker that issued your home loan can repossess your property.
With unsecured debt, your lender does not have access to your assets. They cannot take possession of your house, car or other property in the event you default on your loan. Common examples of unsecured debt include personal loans, payday loans and credit card debt. All three typically carry high interest rates because the lender cannot place a lien on real property and repossess that property if you default.
Debt Ratio and Debt to Income Ratio
Your company’s debt ratio serves as a snapshot of your financial situation. In a recent article for Investopedia, Adam Hayes writes “debt ratio refers to a financial ratio that measures the extent of a company’s leverage.” It compares total debt to total assets, and is not technically the same as your debt to income ratio.
Though acceptable debt ratios vary widely from industry to industry, a debt ratio above 1.0 indicates that your business has fewer assets than liabilities. Alternatively, “a ratio below 1 means that a greater portion of a company’s assets is funded by equity.” How much debt is too much debt depends on your industry.
As Hayes notes in his article for Investopedia, industries with consistent cash flow have more flexibility. Those with “volatile cash flow” have less flexibility when it comes to higher debt ratios. In most cases, however, a debt ratio above 1.0 could indicate to lenders that you are a risky investment.
Understanding the Difference Between Good and Bad Debt When Running a Business
What is Good Debt in Business?
In general, good debt is debt that has the potential to increase your net worth as you pay it off. Put simply, good debt returns money while bad debt takes money away. Good debt typically has favorable lending terms like comparatively low interest rates and longer pay-back periods. Business owners use good debt to finance necessary purchases and those that will appreciate in value — like real estate. A business loan or mortgage loan could be good debt.
In his article “Entrepreneurs: What You Need To Know About Good Debt And Bad Debt” for Forbes, Vahe Tirakyan elaborates. Tirakyan writes that good business debts are those “borrowed by entrepreneurs to pay for items that will contribute to growth and development.” Businesses choose to take on “good debt” because debt is typically less expensive, less risky and less legally complicated than financing with equity. Taking on good debt can also make financial sense — especially for business growth — because borrowers are entitled to a number of tax breaks.
What is Bad Debt in Business?
As noted above, the primary difference between good debt and bad debt is that bad debt takes more money than it provides. Good debt allows you to grow your business without threatening to put you out of business.
In his article “What Is Good Debt and Bad Debt for a Small Business?” for the U.S. Chamber of Commerce, Dan Casarella elaborates. Casarella writes that businesses might borrow money “to purchase a depreciating asset that won’t go up in value or generate any income.” According to Casarella, “that is commonly considered bad debt.”
The hallmarks of bad debt are “high interest rates, fees and strict loan repayment terms.” As such, payday, cash advance and certain personal loans are considered bad debt. Bad debt is often taken out of desperation rather than opportunity. Quoting attorney Lyle Solomon, Casarella notes that these types of loans “‘target people with bad credit or low income with few options to consider.'”
Credit card debt can also be considered bad debt. This type of debt often comes with variable interest rates that make it hard to pay off an existing balance. Interest payments that change in times of economic turmoil — like our current period of high inflation — can put business owners underwater financially.
IRS Definition of Bad Debt
The IRS defines bad debt differently. It is important to understand the IRS’ definition because only bad debt that meets their criteria is considered tax-deductible. In her article “How to Write Off Bad Debt” for Bankrate, Holly D. Johnson explains. Johnson writes that the IRS considers bad debt that which “was made with the intention of being repaid but is now uncollectible.”
In order to qualify for a tax deduction, the debt in question must be related to your business — not your personal life. According to the IRS, bad debt includes “business loan guarantees” and “loans your business made to clients, distributors, employees or suppliers.” They also include “sales to customers made on credit.” Bad debt is sometimes referred to as “worthless debt.”
How Much Debt is Too Much?
As briefly outlined above, how much debt is too much debt depends on your industry and your own business. However, there are signs that your business might be carrying too much debt. If your business’s debt makes it inflexible, this could mean you are carrying too much debt.
In her article “What Are Business Liabilities?” for The Balance Small Business, Jean Murray explains. Murray writes if too much business income “is spent paying back loans [you might not be able] to pay other expenses.” Debt amounts that make it difficult to manage your business could be too much debt.
When Should You Take on Debt?
Borrowing money often makes sense when small business owners hope to expand. Businesses might borrow money before offering new services, opening a second location or taking on additional staff. Some owners of small businesses also take on small amounts of debt to boost their credit scores. This can make them more desirable to lenders in the future. If you are considering a major purchase in the future, this could be beneficial.
Are You Responsible for Your Business’ Debt and Vice Versa?
Business owners often ask if they are responsible for their business’s debt — or if their business is responsible for their personal debt. The answer depends heavily on how you structure your business.
In her article “Are You Personally Liable for Your Business’s Debts?” for NOLO, Shelly Garcia explains. If you are entirely separate from your business, it is less likely “your personal assets can be used to pay for your company’s debts.” To this end, businesses classified as sole proprietorship or partnerships are at greater risk than limited liability corporations (LLCs).
The same is true for your personal debts. According to Garcia, “if you are an owner of a corporation or LLC, you are a separate entity from the business.” Therefore, “the business isn’t responsible for your personal debts.” However, creditors you owe money to personally can still garnish your wages or “take funds your business owes you” in order to reimburse themselves.
How to Minimize Your Business’ Share of Bad Debt
Bad debt typically comes with high interest rates — sometimes variable interest rates — and other unfavorable loan terms. Cutting costs and boosting sales could help you pay off bad debt sooner. However, if your business is already struggling, that might not be possible. Thankfully, there are other ways to reduce the amount of bad debt your business carries. Business owners might be able to refinance or consolidate their debt. In some cases, they might also qualify for tax deductions.
First on our list of ways to minimize your share of bad debt is to refinance that debt. In his article “How to Get Your Business Out of Debt in 5 Steps” for NerdWallet, Steve Nicastro explains how this works. Nicastro recommends refinancing high interest loans before rates climb higher “if you have strong credit.”
If you do opt to refinance a business loan or other debts, know that a new loan will completely replace your existing loan. This could mean a longer loan term and — in the long run — more payments.
Another option is debt consolidation. Debt consolidation could be beneficial to business owners who are struggling to manage multiple loans with different payment periods, amounts and interest rates. Dori Zinn explains how debt consolidation could help in her article “How to consolidate business debt” for Bankrate.
To start, Zinn notes that business debt consolidation typically “works like personal debt consolidation.” It allows you to replace a bunch of loans with a single loan. That loan could provide you with a better overall interest rate.
We explain the business debt tax deduction in detail as part of our recent post “Small Business Tax Deductions Every Entrepreneur Should Know.” According to Georgia McIntyre in her article “21 Small-Business Tax Deductions You Need to Know” for NerdWallet, business owners can deduct bad debt. First, McIntyre explains how the IRS defines bad debt.
To the IRS, it is “‘a loss from the worthlessness of a debt that was either created or acquired in a trade or business.’” From a business perspective, bad debt includes “credit sales to customers,” “loans to clients, suppliers, distributors and employees” and “business loan guarantees.” Consult with your accountant or other financial advisor before claiming this deduction to ensure your debt qualifies.