The Difference Between Good And Bad Business Debt

Business debt is considered good when it is able to more than pay for itself. As savvy business owners, SMEs should view debt financing as a tool, not as a perpetual problem, to enable business growth.

The perception of debt has changed over the years. Some business owners, especially the older generation, have built their SMEs on the principle of never borrowing. However, leveraging is a simple fact of doing business.

Today, taking a business loan is an essential tool for obtaining working capital, affording the right talent, and marketing products in a digital-first, e-commerce world. Here’s how to distinguish between good business debt from bad business debt.

How can business debt be good?

Business debt is considered good when it is able to more than pay for itself. 
The most common example is financing to fill orders. For example, when an SME increases production, it needs to scale up with more supplies and staff to fill the orders on time. These costs may, at present, be out of range for the SME. But they can leverage and borrow against the invoice.

Through trade financing, funds can be used to expand and fill larger production orders. When invoices are delivered and paid for, the SME can repay the loan, and also come out ahead in terms of revenue.

This concept can be broadly applied in many areas, such as financing a marketing campaign to secure sales from new customers, or borrowing to build future, revenue-generating assets to generate larger sales volumes.

Examples of good business debt

1. Debt with low interest rates

When debt is cheap, it makes more sense for an SME to take a loan, and invest its capital elsewhere. For example, current commercial property loans in Singapore have an interest rate of between two to three per cent. If an SME has investment options that yield five to seven per cent per annum, it might make more sense to borrow to buy its commercial space, while investing capital into other revenue-generating opportunities.

2. Monetising non-revenue generating assets

SMEs can take advantage of secured loans to spin cash from non-revenue generating assets. For example, an SME’s excess inventory does not usually generate revenue, until it is sold. But an SME could take out a short term loan against its excess inventory, say a loan of 80% of the inventory value, at a lower interest rate. This may result in having cash to fill more orders and fuel business growth.

SMEs can also borrow against their commercial building, where interest rates are lower, compared to borrowing against the company director’s stock portfolio. Generally, secured loans tend to have a lower interest rate than typical, unsecured business term loans. However, the interest rate will vary, based on the perceived value of the asset.

3. Debt which prevents future rise in costs

Restaurant owners would know many landlords increase rental prices once they see F&B revenues pick up. By purchasing the property outright with a business loan, the SME can ensure that a future cost, such as higher rentals, is no longer a risk.

Another example would be for SMEs that trade commodities. A jewellery company might want to secure a loan to buy more precious metals if there is a high chance of gold prices rising. By borrowing to buy now, the business prevents future price hikes from cutting into profit , at only the cost of the loan. SMEs must also be cautious to balance the total cost of the loan, such as interest repayment and processing fees, against the estimated future costs they face.

4. Debt which maintains cash flow

Consider an SME with a bank balance of $300,000. The SME can choose to borrow $300,000 to purchase much-needed equipment, or use its current cash balance to pay the full amount.

If the SME were to borrow $300,000 to purchase much-needed equipment, it would still have a balance of $300,000 in the bank. If the SME paid $300,000 to buy the equipment and not take a loan, it would be left with $0 in the bank. In the second example, the business is debt-free but is now at risk of not being able to pay staff and suppliers during a dry spell, or take advantage of business opportunities. It could potentially be in a riskier position than the one that borrowed $300,000 to buy the equipment.

As such, businesses must be careful not to rely on oversimplified notions that debt is always bad. It is possible for a thriving SME to incur business debt to maintain cash flow, which allows them to keep suppliers and staff paid, while giving customers more time to process repayment.

5. Consolidate debt repayment

A debt is good if it repays other business loans, at a lower interest rate. For example, say a business has $500,000 outstanding in various high interest, unsecured loans. If the business can secure a $500,000 loan at a lower interest rate, it could use this single loan to repay all outstanding debts.

This consolidates all business debts into one loan, which looks neater on the books, and reduces total interest repayments. SMEs with multiple credit lines or numerous smaller debts should consider taking steps to consolidate business loans this manner.

6. What is bad business debt?

In general, business debts that fail to generate positive returns should be avoided at all costs. Unpaid invoices and rollover debt on corporate credit cards are the most common culprits of bad business debt. Another example would be financing projects of little quantifiable value, such as a $50,000 renovation loan to outfit a designer office, when most meetings are conducted at the client’s premises. 

As savvy business owners, SMEs should view debt financing as a tool, not as a perpetual problem, to enable business growth. The correct use of debt is essential to scaling up, as the alternative is often to surrender equity, which can amount to giving up much more than a few interest repayments.

Fortunately, SMEs in Singapore have several loan options. As a world-class financial hub, service providers in Singapore offer business term loans, microloans to cover daily operations, even trade financing to cater large orders and business expansion. SMEs can start by checking nonbank financial services, such as P2P lenders, which do not require high-cost collateral or a long business history to disburse a business loan.  

This article is contributed by Validus Capital, a leading growth-financing fintech platform that connects accredited investors with growing SMEs across Southeast Asia.

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