Good debt vs Bad debt

The US financial crash of 2007/8, now referred to as The Great Recession, has given us more than a decade of record-low interest rates. However, while there are suggestions that interest rates are turning, it will be some time before they reach anywhere near historic levels. Consequently, this has created an interesting debate regarding good and bad debt and how businesses can take advantage of the current situation.

We will now look at various issues to consider when looking at debt to grow your business in the short, medium and long term.

Respect debt, and it can be your friend

Many of us baulk at the idea of taking out a loan to fund a business, improve cash flow or maybe negotiate the purchase of equipment. The idea of taking on long-term debt can be frightening, but it is crucial to put it in perspective. Let’s face it, without mortgage debt, how many of us would ever have bought that dream family home?

The reality is that debt offers a potential shortcut to a particular goal, whether this is personal or in business. It is also essential to be careful of the level of debt that you take on and be sure you can afford it. Stretching yourself to the limit may be attractive at the time, but if you cannot keep up with debt repayments, this can make a challenging situation much worse. So, you need to find a balance between positively utilising debt while leaving yourself some headroom in the event of unexpected expenses further down the line. Challenging but not impossible!

Respect debt and debt can be your friend, show no respect, and it can destroy you.

Worldwide interest rates

As we touched on above, worldwide interest rates collapsed as contagion ripped through the financial markets in the aftermath of the US sub-prime mortgage crisis. While many financial experts and central banks expected a degree of contagion, nobody forecast the devastating aftermath. Here we are 14 years after the initial turmoil began, and interest rates are still rock bottom. Even though many experts predicted an uptick in base rates a couple of years ago, COVID led to further delays and uncertainty.

The US Federal Reserve and the Bank of England are just two of the leading financial bodies to indicate an upturn in base rates is not too far away. So, where does this leave businesses regarding the use of debt refinance and growing their sales?

What is good debt and bad debt?

There is no one-size-fits-all definition of good and bad debt; it is all relative. For example, if you borrowed £10,000 to shore up your business but could not keep up with repayments, that would be bad debt. Alternatively, if you borrowed £1 million to update equipment and improve efficiencies in your business, leading to an additional £100,000 a year in profit, this makes sense.

This then brings us onto the short, medium and long-term considerations for debt. Taking on new debt, which improves your business profitability, on the surface, makes sense. However, where does this leave you if the benefits of investment are not felt until the medium/longer-term?

It is all good and well having medium to long-term plans, but if you cannot finance debt in the short-term, you may not make it to the medium/long-term. Consequently, you may never feel the benefits of a perfectly bone fide investment in your business. Cash flow is an essential element of any business, whether a start-up, growing, or mature company. Unless you have the cash flow to fund your short-term debt liabilities, all of the medium to long term benefits in the world will not make a difference.

So, when looking at good/bad debt, it is relative to the impact this will have on your business and ultimately whether you have the cash flow to keep up with repayments. There are numerous ways to take advantage of relatively low-interest rates to strengthen your business.

Refinancing company debt

Many businesses use debt, as we touched on above, as a shortcut to long-term profitability. Indeed, there is an argument to suggest that cash in the bank should be invested in the business and not left sitting idle, especially when you bear in mind savings rates at the moment!

So, if your company currently has various debts with, let’s say, an average interest rate of 12%, debt refinancing may be an option. Even though you can cover the current payments, if you were to refinance your debt at, for example, 8%, this would crystallise a 33% reduction in your interest charges. These are funds that could be invested back into the business for short, medium and long-term benefits.

When approaching a lender about refinancing company debt, they will look at the state of the business and cash flow. However, if you have had no issues covering interest payments at 12%, then it stands to reason you will have no problems at just 8%. In many ways, this is a win-win situation for businesses, reducing interest charges and releasing funds for investment back into the business.

Equipment loans

Equipment loans are sometimes a bone of contention for business owners, many of whom prefer to run their existing equipment into the ground. While on the one hand, this makes sense, maximising the cost of the equipment, on the other, there may be efficiency benefits to consider. Let us consider a situation where Company X is currently able to produce 10,000 widgets a day. Maintenance bills tend to increase as existing equipment gets older, and efficiency will often decrease. When should you consider an equipment loan to update your machinery?

As technology is forever moving forwards, there may be a machine that can produce 15,000 widgets a day. This is an increase of 50% with no additional labour costs, although it would mean an investment in new machinery. However, all things being equal, it is fair to say that the machine would effectively pay for itself with the considerable increase in productivity. This could open up new markets, help secure new contracts, and positively impact the business.

There are few scenarios where business owners are considering an investment in new equipment, which are as clear cut as the above example. However, whatever the situation, there are numerous issues to take into consideration such as:-

  • Efficiency gains
  • Productivity gains
  • Maintenance costs
  • Cash flow

That moment when you feel “forced” to invest in new equipment probably means that you have left it a little later than you should have. Business owners need to be aware of improvements in technology, potential efficiency and productivity gains, balanced against the cost.

Employee count

When businesses invest in new machinery to crystallise efficiency and productivity gains, this can often negatively impact employee morale. In some cases, yes, there may be a reduction in employee numbers due to efficiency gains. However, in many cases, the employees will be deployed in other areas of the business.

As a business owner, it is crucial to recognise the value of the skills and experience across your workforce. You may find that many transferable skills can assist with long-term growth and save on future training costs. One example is the health insurance market in the US.

In recent years we have seen the introduction of automated claims processing which has reduced the level of manual entry and checking. In addition, artificial intelligence means that the software packages can effectively “learn on the job”, leading to further efficiency gains in the future. At first glance, it may look as though data entry clerks would no longer be required, leading to redundancies. However, in reality, many of the healthcare insurance carriers redeployed employees in customer-facing roles. This led to a significant increase in customer satisfaction levels, improved customer retention, and, more importantly, improved employee satisfaction with employees taking on more challenging roles.

Planning for the future

As a company, you should be planning for the future on an ongoing basis. This may involve relatively minor tweaks to your business, wholesale reorganisation or the use of equipment loans to improve efficiency and productivity. The risk of taking on debt is relative to the short, medium and long-term benefits. Good debt will enhance your business, while unfortunately, bad debt may simply prolong the agony and eventual demise.

Summary

Everything is relative when it comes to business and especially business debts. If you respect debt, invest wisely and keep up with your repayments, there is no reason why it can’t work for you. However, those who continuously take on additional debt to shore up their business balance sheet, with no focus on long-term improvements, are often fighting a losing battle.

Investment in equipment is also a crucial area of business. Over time, your existing equipment will become less reliable, maintenance costs will increase, and your efficiency/productivity levels against new equipment may not compare favourably. It would be naïve to suggest there is no risk in taking on business debt. However, we will leave the final word to world-renowned entrepreneur Warren Buffett:-

“Risk comes from not knowing what you are doing.”