WEV’s Smart Money: Debt Financing: the good, the bad and the ugly

July 6, 2018  In an ideal world, every small business owner would already have saved the $5,000 or $10,000 (or $50,000) they needed to get started, purchase that key piece of equipment, take on another staff member, or upgrade their website, in order to generate sales revenue and positive cash flow.

For many small business owners, however, these funds are not readily available, as every spare dime may be cycling back into the business in other ways, such as paying the rent or buying inventory.

In these circumstances, a business owner can feel paralyzed: they know they need to put something else into the business to take it to the next level but they do not have the funds on hand. Some business owners may also be reluctant to borrow money at all, thinking that all debt is “bad”. There are certainly debt products out there that are riskier and more onerous than others but not all debt is created equal.

The key number that you need to pay attention to is the annual interest rate or “APR” – you obviously want this number to be as low as possible. Beware that some lenders now quote interest rates on a monthly or even daily basis so that they can appear low – these rates may not be as good as they seem once you equate them to an annual basis.

Below is a summary of some of the potential characteristics of “Good”, “Bad” and “Ugly” debt:

Good Debt

  • Debt is being taken on to specifically fund an investment in the business which will increase its net worth
  • Low interest rate – a low interest rate for a business loan is one that is typically between 4% and 14% APR. (Do not get confused with mortgage interest rates, which currently hover at or below 4% APR). A low interest rate on a credit card is 0% to 5% (but see the note below about credit card use)
  • Borrowing Term is matched to investment useful life (i.e. you won’t still be paying off a piece of equipment that became obsolete several years ago)
  • Established lender who understands small business needs
  • No penalty for early repayment

Examples: business loan from WEV; business loan from SBA; business or personal line of credit guaranteed by personal asset with established lender; equipment or car lease/loan from established lender.

Bad Debt

  • Debt is being taken on to fund products or services that do not add value to the business
  • Moderate to high interest rate (16% to 30% APR)
  • Extremely short or extremely long debt terms (short debt terms can result in very high repayments which can choke up a business’ cash-flow; long debt terms can result in you paying a high amount of interest over the course of the loan)
  • Debt provider keeps trying to push more debt products

Examples: Store credit cards; certain online loan or credit products; some invoice factoring

Ugly Debt

  • High interest rate (25% APR and up)
  • Short repayment period (one year or less)
  • “Hard-sell” from debt provider to take on more products (multiple emails; letters, etc.)
  • Repayments may be taken from POS/bank account on a daily basis

A note about credit cards – good, bad, ugly or all three?

When used with discipline and care, low- or zero-interest rate credit cards can be a convenient form of debt finance for small business owners in a crunch. Avoid using credit cards to pay for everyday business expense unless you KNOW that you can pay off the balance in full at the end of each month, and not incur any interest. Only consider using a credit card in this way if you gain additional value from using the card – e.g. accruing air miles if you need to travel a lot for your business. If you choose to use credit cards in this way, practice discipline, discipline, discipline!

Final word

Before deciding if you should borrow the money you want to grow your business, you need to look at a key determinant: will the projected increase in sales revenue from making that investment (the return) exceed the cost of any borrowing needed to make that investment? If you can confidently answer “yes”, then seek out some “good” debt to move your business forward… but, remember, the best debt is one that has been repaid.

Introducing WEV’s Smart Money, a monthly article by Business Recovery Specialist, Nicki Parr. Each month, Nicki will share insights and tips to help small business owners feel more cash-confident and economically empowered. If you have a finance-related question that you would like answered, email Nicki at nparr@wevonline.org.