The Business Debt Trap

Debt comes in two forms - Good and Bad. Successful businesses understand the difference and actively manage their position.

Over the years I have seen many businesses struggle (and some crumble) under the burden of debt - with the debt load literally hanging over the business like a tree branch waiting to fall in a strong wind. Using a simple test before taking on debt will assist you in avoiding this risk.

But......to start with - not all debt is bad!

In fact, debt can be a great enabler to get a business going, be it for a vital piece of equipment, funding some growth or at a personal level - to buy that first house. Debt is merely a tool and as with any tool - it can be used well or......poorly.

So what is "Good" debt versus "Bad" debt?

My simple definition for “Good “debt is that it is funding something productive. Ideally in a business this is something which is "enabling" the creation or increase of a revenue stream or enterprise value. For example, this may be the purchase of stock for resale, a new piece of equipment which will increase production capacity, or even the purchase of a business to allow vertical integration of an existing purchase line. All of these items can build the business, create enterprise value and enhance the overall business position.

Naturally care still needs to be taken with good debt to ensure that the terms are right and that you don't overextend your cashflow.

"Bad" debt - this is the funding used for the toys (flash cars, non essential equipment etc). Items which are simply "nice to have" should never be debt funded. Other bad debt is debt used to cover cashflow gaps caused by poor management controls - ie. poor purchasing, poor debtor collections, or payments etc. Terms such as "waste" and "excess" are commonly used by bankers to explain what bad debt was used for.

Bad debt is generally debt that a business did not need have and will simply drain margin from your business.

The good news - is that with a little discipline and the following test, you can avoid the debt trap of taking on unwarranted bad debt.

When you are considering taking on a new or increased facility - answer the following questions:

Test # 1. Productive. 

Will the debt be productive - is it funding an income earning item? If yes, continue to point 2, otherwise re-evaluate whether you should be debt funding this item. Often it is better to wait and "save" for these non-productive items instead.

Test # 2. Quantity.

Buy what you need and what you can use - and not necessarily what's going to give you bulk discount or scale. I visited a client once who "got a deal" on photocopy paper - 4 pallets worth - a sensational deal apparently, right up until we worked out that this equated to 3 years supply - during which he was funding and storing it! Another common one is floor space, where significantly larger spaces are taken (purchased or leased) but not used. Buy only what you need and then borrow the lesser amount.

Test # 3. Quality.

To explain quality, I use the analogy of "why buy a Rolls Royce when a Mini will do" - feel free to insert the cars of your choice, but I'm sure you get the picture. Often business buy the very top of the range item when a cheaper version would meet their needs. Do your research, check out the prices, the efficiency, ongoing warranty and maintenance items, along with reliability stats. The cheaper version will invariably be less efficient etc - which is why you are paying less in the first instance! Be sure that you are buying the most appropriate quality for your business, and not just the item with the best sales presentation.

Test # 4. Affordability

A critical component of any loan application is whether the business can afford it. Do the math, revise your forward cashflow and ensure this new debt is viable. If the numbers don't work, then it is prudent to delay the new loan until they do.

If you apply these simple 4 tests every time you consider borrowing money, I can guarantee that in the long run you will; 1.borrow less, 2. borrow more wisely and 3. save thousands in the process.

Be mean with your money and even meaner in what you need to borrow. The simplest way to reduce your borrowing costs is to...borrow less...and for the dollars that you do borrow, make sure they are working as hard as you. 

With good planning and strong awareness, you will avoid the Debt Trap!