Understanding Business Debt vs Good Debt

According to statistics, about 309,000 businesses in Canada missed at least one debt repayment, indicating that companies are under high debt pressure. Although this may paint a bleak picture of taking on debt to help your business grow, it’s important to know that not all debt is created equal. There is bad business debt and good debt, but it’s important to understand the implications of each.

Today, our team at Bizfund shares what you need to know about the differences between the two, alongside teaching you better business debt management. It is our aim that you’ll walk away with the knowledge of when to take on business debt and when to put acquiring more money through debt on the back burner.

Good Debt Defined

You already know that not all debt is created equal, but why do we say this? Below, we define good debt, explain what it looks like in practice, and outline how to measure return on investment when borrowing. So if you’re looking into good debt vs bad debt for a business, this is the framework you’ll need to make better decisions.

Investment That Generates Returns

Good debt is funding you secure to significantly increase your business’s earning potential or long-term value. It isn’t debt you take on just to have access to funds. When debt helps your business generate more income than it costs, it’s a viable tool in your arsenal for success.

Common Examples Of Good Debt

There are quite a few examples of good debt. For example, good debt is funding you borrow to purchase equipment that improves business efficiency. It is also debt that lets you buy inventory ahead of your busy seasons. It’s even debt that allows you to invest in marketing that drives qualified leads to your doorstep.

There is a reason these examples qualify as good debt. The reason is that there is a clear connection to revenue generation or operational improvement.

Measuring ROI On Borrowed Money

An important part of ensuring debt is good debt is measuring the ROI. You need to measure the ROI on the money you want to borrow before you borrow it. This sounds more complicated than it actually is. All you need to do is estimate how the capital will reduce costs, increase revenue, or improve margins.

Once you have this estimation in monetary terms, you can compare. You’ll compare this projected gain to the total cost of borrowing, including fees and interest. Should the number you come out with support growth and cash flow stability, there’s a high chance borrowing will result in good debt.

Bad Debt Warning Signs

So, how exactly do you know if taking on debt is a bad move? It’s simple, you look out for a few warning signs. If you know the warning signs, you have a better chance of making better business debt management decisions.

So, with this in mind, here’s a quick look at the signs that show you may want to forego taking on anymore debt for the foreseeable future:

• Reliance on borrowing funds for routine operating expenses. If you find that your business consistently uses credit to cover inventory, payroll, rent, or utilities, it is a clear sign of a serious cash flow issue. This is not simply a short-term gap. In these situations, taking on more debt can be incredibly detrimental to the company. 
• Taking on new debt to cover past mistakes. Every business makes mistakes, but if you find that your company is using loans or credit to fix past financial missteps, it can very quickly create a vicious cycle that is difficult to break. You shouldn’t be taking on debt to patch recurring mistakes.
• Blurring the line between lifestyle and business spending. With some companies, it’s easy to blur the line between lifestyle and business expenses. This is one of the biggest red flags signalling you’re using debt incorrectly. When you use business credit or loans for your lifestyle, it’s harder to track performance and manage repayment responsibly, so it’s important to set clear financial boundaries.

When Taking on Debt Makes Sense

If you’re still unsure of the situations where taking on debt makes sense, you may find the following insights beneficial. Each of these points outlines when debt makes sense, and knowing this can help you manage your business debt.

• When the numbers support your decision. If your company’s projected margin, revenue, or efficiency gains clearly outweigh the cost of borrowing, it’s possible that taking on debt can be a growth tool and not a financial burden.
• When the timeline is defined. If there’s one thing you need to remember, it’s that debt works best when there is a clear repayment plan you can tie to a specific contract, milestone, or revenue cycle. When this is the case, there is less of a chance of debt becoming ‘bad debt.’
• When the debt solves a temporary constraint. Short-term financing, such as loans and merchant cash advances, can help your business bridge predictable cash flow gaps and seasonal fluctuations. So, if borrowing will help get your business through a tricky situation and won’t negatively affect your company in the long run, it’s worth considering.

How Much Debt is Too Much?

Unfortunately, there isn’t a single number that defines ‘too much’ debt. We wish there were so that we could share it with you. However, be that as it may, there are clear-cut indicators that you can use to assess the risk of debt becoming ‘too much.’

The first indicator is the debt-to-equity ratio metric. This metric helps you compare your business’s total liabilities to shareholders’ equity. A higher ratio may indicate greater financial leverage, but it can increase your risk exposure if your revenue slows. Conversely, if you have a lower ratio, you can still evaluate the benefits of borrowing based on your expected return on funds and cash-flow stability.

Another indicator is industry benchmarks. You need to consider your industry and decide when taking on more debt would be too much. For example, what’s manageable in manufacturing or construction might not be for a service-based business with lower overhead.

It’s also important to bear in mind that your comfort levels also play a role. If you feel that payment obligations would limit your ability to make strategic decisions or cause constant cash flow stress, it could be a sign that your debt load is exceeding what’s healthy for your business.

Managing Business Debt

For Canadian companies, managing business debt is a core part of long-term stability.

Based on findings from Statistics Canada, an estimated one-quarter of small businesses and medium-sized companies made requests for external debt financing in 2023. Most of these businesses secured the finances they needed. This indicates that more companies are looking into and securing financing for operations and growth.

However, the key to borrowing is managing your business debt so it supports your business rather than causing unnecessary pressure. If you would like to learn how to approach managing business debt, here are three steps to follow:

Step One: Prioritizing High-Interest Debt

The first thing you need to do is list all outstanding debts, including merchant cash advances, credit cards, and short-term loans. Listing all your debt obligations helps you get a big-picture overview.

You can see what you can pay down faster, what is better left paid per its agreed-upon terms, and whether or not you’re in a position to take on more debt. However, it’s usually recommended to pay off balances with the highest interest rate or factor rate first. This is because these debts tend to create the most pressure on daily and weekly cash flow.

Step Two: Exploring Refinancing Options

If your business has become more stable and its credit profile has improved, you could consider refinancing options. In many situations, refinancing is a great business-debt management tool, as it allows you to turn high-cost, short-term financing into lower-rate term loans or structured facilities.

These can help reduce monthly payments and improve financial predictability. You’re also not extending debt indefinitely by refinancing; rather, you’re better aligning payments with your business’s actual revenue cycle.

Step Three: Building A Structured Payoff Plan

The last thing you want is for your debt to become reactive, which is why it’s best to build a structured payoff plan to better manage it. A payment plan allows you to map out timelines, regularly revisit projections, and set milestone targets.

This reduces stress, helps you stay on top of your debts, and allows you to settle them faster, thus enabling better financing opportunities in the future when you need them.

In Business Debt Management, Debt Is a Tool, So Use It Wisely

At the end of the day, debt is neither good nor bad on its own. It only becomes good or bad based on why you take it on, whether it genuinely improves your financial situation, and how you structure it.

We see Canadian businesses borrowing every day to stabilize cash flow, grow, and expand operations, and the difference for them usually lies in planning and debt management. If you’re weighing financial decisions and are unsure if your current debt structure is working in your favor, it might be worthwhile to speak with an advisor or lender like Bizfund.

Our team can help you evaluate if funding through a merchant cash advance would be a ‘good’ debt move. You can contact us here, and our experienced team will reach out to you.