566 – Good Debt Bad Debt
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Welcome to the How of Business with your host, Henry Lopez. The podcast that helps you start, run, and grow your small business. And now, here is your host.

Welcome to this episode of The Howa Business. This is Henry Lopez, and this episode is about good debt and bad debt. If you see all debt or loans, even in business, as bad debt, then I would like to challenge you to reframe how you think about debt, shifting from mostly a fear-based personal finance mindset to a strategic business mindset about

debt. So on this episode, I'd like to introduce you to several concepts that will help you recognize opportunities to leverage good debt to drive sustainable growth for your small business and still avoid the pitfalls of bad debt. You can find all of the Howa Business resources, including the show notes page for this episode, and learn more about my one-on-one and group coaching programs at thehowabusiness.com. I'm

I also invite you to please consider supporting this podcast on Patreon and please subscribe wherever you might be listening so you don't miss any new episodes. I'll have available a free download, a smart business borrowing checklist at the show notes page for this episode. And it's a checklist that will help you evaluate as it relates to considering taking out a loan or getting debt, whether it's strategic and a smart move or not.

So go to thehowabusiness.com, search for the show notes page for this episode, and there you'll find this free download that I'm calling Smart Business Borrowing Checklist. So let's talk about good debt and bad debt and how to leverage debt without losing control. In personal finance, as I've mentioned, debt understandably is seen as a trap. And for a good reason, consumer debt in particular is bad debt.

It's debt that costs us lots of money because the interest rates are so high. But in business, debt done right is essential. And so I'm going to explore how smart entrepreneurs use strategic borrowing to launch, grow, and even adapt or adjust a business while staying in control, while not letting that debt get out of control relative to the revenues of the business. So if you're wondering how much debt is too much debt,

or when it's smart to borrow, then this episode is for you. Most small business owners carry personal debt baggage into their business thinking, whether that's because they've had a bad experience with debt or they're in debt personally, or of course, we all hopefully have been taught and learned that consumer debt is bad.

and all those things are true. But then we apply that to our thinking of leverage when it comes to business, and that limits us greatly. It will be hard to grow just bootstrapping alone. At some point, that will not be enough, even if it is enough to get started. Business and personal finance essentially play by different rules is the way we have to look at it. Strategic debt

in a small business will help you grow faster, take advantage of opportunities that might present themselves, and of course, most importantly, to preserve your own capital, your cash, so that you can do something else with it, even if it's to keep it invested elsewhere.

Without leveraging debt, you're likely going to grow too slowly. And you're also, without leveraging debt, risking your personal savings, your cash, your capital that could be invested elsewhere. Maybe by leaving it in your 401k or leaving it in the equity of your home or in savings or in the stock market.

So it's about shifting our mindset from what works when it relates to personal debt to how we need to think about it when it relates to business debt. Consumer debt, again, is usually for consumption, for a car or vacation or clothing or jewelry.

All of those things, while we might have the memories of it and we might enjoy it in the moment, all of those things have one thing in common, and that is that they depreciate. We're not buying things that either generate income or appreciate. Certainly, we can argue that an exception to that is our home or if you have investments in rental property, but that doesn't count. We're talking about our personal consumer debt. When we buy a home, for most of us, homes are at a price point where we can't afford to buy a cash home.

So we leverage debt there and we hope that the home will appreciate over time and offset some of that interest that we're paying on that loan. But again, the mindset that we bring to business often can be, I want to eliminate all debt. I want to be debt free. I want to pay for everything as much as possible with cash or get rid of debt as soon as possible. And of course, that does make sense.

when you're talking about high interest consumer debt. But business debt can be used to fund assets. And if we understand the pure definition of the word asset, it is something that either directly or indirectly generates income or revenue. So business debt can fund assets that appreciate or generate income, like equipment or additional staffing or spending on a marketing campaign.

Good debt is leverage towards ROI, a better return on investment. Bad debt is used to avoid a short-term discomfort or desire. This is Henry Lopez with a quick message about our show sponsor and trusted service partner, The Franchise Guide. Giuseppe Grammatico is The Franchise Guide, and he provides expert consultation services to help you find the right franchise small business. If you are considering a franchise business, I recommend consulting The Franchise Guide.

Giuseppe is a franchise veteran who simplifies the process of franchising and excels at guiding his clients to the franchise model that best suits them. He helps people like you find flexibility and freedom in their lives through franchise business ownership. And as your guide, he will help you answer any of your questions about franchises. Once he gets to know you and what you're looking for, he creates your own personalized model and shows you which franchise opportunities are a best match for your needs and preferences. The best part?

It's all free. There's no catch. Like with real estate or business brokers, Giuseppe's fees are paid by the franchise company. So if you're interested in a franchise business, take the first step and schedule a free, no obligation call with Giuseppe. To learn more and to schedule your consultation with the Franchise Guide, please go to the show notes page for this episode at thehowabusiness.com. There's also a link to the show notes page in the description of this episode.

So let's talk a little bit more about what good debt might look like. Well, incurring debt in a small business can support revenue growth, asset acquisitions, as I just mentioned, and perhaps also very critically, working capital for the businesses that require more of that, either because you have a cycle to your business or you have to make large inventory purchases periodically, or you've got a large...

receivables outstanding. Any of those combination of reasons might be reasons why you periodically need to dip into working capital. And we can either have that sitting there in cash, which is certainly not a bad idea up to a certain amount, or we can leverage things like lines of credit. So that's an example of

of good debt in a small business. It could be that initial SBA loan that you get to fund the startup of your business. It could be a line of credit, as I just mentioned, that you tap into when you need it for short periods of time. It could be financing offered by an equipment manufacturer or distributor, allowing you to buy the equipment or the vehicles or the tools that you need

to increase capacity and to bring on more clients and of course, thereby increase revenues. And you can also responsibly use business credit cards in the business wisely. Now, of course, those are going to have high interest rates. So as with personal financing, we don't want to carry large balances on those credit cards, but we certainly want to use them even if it's just

by paying them off at the end of the month so that we get a little bit of float that 30 to 45 day in the billing cycle. And also nowadays with all of the availability to get points or some other type of rewards for that spend on that card.

Not to mention that eliminates having to have cash or write checks. And so it facilitates a lot of things in a much more secure manner. So those are some examples of what good debt might look like in a small business. Now, on the flip side, that doesn't mean there can't be bad debt.

Bad debt, for example, is if you're covering the ongoing losses in your business because you're supporting a particular lifestyle that the business model really cannot afford. It's a business that isn't profitable enough. And one of the ways you're offsetting that is by incurring more debt or putting more things on a credit card.

Well, that in the end is going to crash and burn, obviously. And so that type of using of high interest, short-term loans, whether it's a credit card or other loans, you know, every time I sign on to PayPal, I get offered a loan. And the thing with those loans is you pay an exorbitant interest and you pay it upfront.

So they get you whether you pay that off early or not. Now, if that's the only option you have, understood. You got to do what you got to do at least sometimes to keep your business afloat. But if that's where you're relying on on a regular basis, your business is in trouble and you're just extending the inevitable, which is that it's going to crash and burn because that debt is going to

overwhelm your ability to pay it back and the interest will kill you over time, just like it can in our personal finance. So you cannot use debt to postpone fixing a broken business model. You cannot continue to put cash into a business that has a broken business model.

Now, that's not to say that, of course, we don't need to put in cash initially, or we might invest more capital to expand partly. We might invest some of our capital and borrow some of the capital. But if every year you're putting in more cash to keep the business afloat,

That's an example of bad debt and bad usage of your cash. So how do we determine the right amount of debt? Certainly there are ratios out there that large organizations use that I think can apply. So I'll share some of those with you here, and it'll be in the checklist that you can download.

But there are ratios of debt relative to revenue that are ideal. And those are called leverage rate ratios that you might want to look at. And so I'll spell those out in the download. But those are a couple of KPIs or measures that you look at to see, am I below...

the threshold or maybe getting into a yellow zone or danger zone on how much debt I have in the business relative to either my assets and or my revenues. So apply those formulas and that'll help you with a guideline as to whether you've got too much debt or you still have ample capacity to take on debt if it makes sense. Separately, I think it's also always great to have operating reserves and

And there's different opinions on how much, but I like to have at least two to three months of operating reserves, meaning if $0 came in, how much would I need to cover three months worth of my fixed expenses? Now, you might do that math and say, oh my gosh, that's way too much cash. There's no way I can have that in the bank. Well, then work towards that over time and or some cash along with a line of credit,

might be how you handle having enough of that working capital in case of an emergency, but also in case of an opportunity to take advantage, for example, of a discount by increasing the order for our inventory. So,

So those opportunities might present themselves, but if you don't have enough working capital, you may not be able to leverage those opportunities. And then obviously what you're trying to do is you're trying to balance it such that your debt service, which is what we call the payments that you're having to make on the

principal and interest on all of the debt you might have, that that doesn't take every dollar that you're making. That's not going to work, obviously. There's got to be enough money there to distribute to compensate yourself and to invest in the business as well. So those are the things you look at to determine how much is the right amount of debt. And of course, every business and every situation is slightly different, but there are some best practices there.

The key is, of course, that we're trying to preserve our own capital, our own cash. We want to, within reason, minimize how much of our own cash or the business's cash for that matter that we put into the business. And we want to leverage debt the right way at the right ratios so that we can generate revenues and generate ROI on that borrowed money, not just our own capital.

There are a couple of other concepts that partially come into play here as we think about using and leveraging debt in small business. One is the time value of money. And I know it doesn't completely apply here, but what I want you to think about now is that acting now yields more return than saving for later. So whether it's

adding that additional capacity by more equipment or a larger location or another vehicle or another employee, if we wait until we have saved the money to afford that investment, we're missing out on growing and on generating revenues now. So acting now yields more return than saving for later. And we act now in part by leveraging smart data.

debt. So I might have saved 50K in loans now, but that is leveraged over time, especially if I can get that spread out over five years, let's say. And that investment now with very little or no of my cash investment might generate more than even the whole cost of the debt in year one. You've got to do the math to make sure that's the case. And that's where we have to be very careful to justify these expenditures. But that's the idea. That's where we want to leverage

to invest in assets that allow us to generate more revenues today. And also then the other concept that comes into play is opportunity costs. So if we tie up our own capital, whether capital that's in the business or our own capital that we might add

or invest further in the business. If we tie that up today because it's being used in the business or tied up in assets, we can't use it for other higher return activities that might present themselves. So liquidity is agility, having that flexibility and always having that ability

opportunity to take advantage of things that present themselves. So time value of money and opportunity cost, I think apply as well as to why it makes sense in the right ratios to incur debt to help us start and grow a small business.

So some additional rules to think about are best practices for borrowing money. You want to borrow with purpose, with a plan, and of course, understanding what the debt service is going to be and what the repayment plan is going to be. Now, that's not to say that you should be anxious to pay back debt.

If you've got relatively low interest debt, don't be in a hurry to pay that off unless it makes absolute sense. If you've got high interest debt, that's what you should be focused on paying off, just like in personal finance. But good debt, like a good SBA loan that might have a 15-year term at a decent rate, rarely does it make sense to accelerate paying that off, at least not initially.

So you want to, of course, understand all of the loan terms when you are considering debt. You got to be very careful there that you understand everything about that debt. And how does it compare to the life of the asset? Plan for best and worst case scenarios as well. So you want to validate and stress test your planning when it comes to borrowing. Get help if you need to with this. Your CPA might be a great resource to help you think through this and calculate this and put some

numbers to it to help you make a decision on how do you responsibly borrow money in your business. Now let's explore a little bit more about the emotional side of this mindset of borrowing debt, good debt, bad debt. Strategic borrowing, the good debt, is about smart leadership and it's not about desperation.

We're not borrowing because we're trying to stay afloat. At least we shouldn't be doing that too often or for too long. So some of the common myths that I would like to address here, all debt is bad. Well, hopefully if you've listened this far, you understand and agree that that's not the case, that the right amount of debt at the right ratios, especially if we're investing in assets or things that help us grow a business, is usually good debt.

Bootstrapping, as we've all been taught to think, might be essential and necessary initially, of course, if we've got no access to loans or to debt, but eventually you will not be able to grow fast enough. You will always be burdened by not being able to take advantage of the opportunities. So bootstrapping is great. It's important. We want to reinvest in our business. But at some point, if you're going to grow beyond that initial stage, you probably need to leverage borrowing money.

And the other misconception is that borrowing means failing, that somehow you weren't able to save for that. Well, sure, that applies often, if not always, when we're talking about personal finance. But in business, that's not the case. That's simply false. And cash is king.

However, debt protects it. So think about that. Cash is king, but debt protects that cash, right? Because if I will keep that cash so that it's available for when I need it or for when an opportunity presents itself and leverage it against the right amount of borrowing, well, now I'm really protecting my cash.

So remember to go to the show notes page for this episode and download my smart business borrowing checklist. It just has a lot of these points that I'm making about how to evaluate whether it makes sense to take on strategic debt and whether it's a smart move for your business. So go to thehowabusiness.com and download the smart business borrowing checklist.

So some final thoughts on good debt and bad debt. I want you to look at debt as a tool and how you use it is what matters. Avoiding all debt out of fear or that mindset that debt is all bad can be more dangerous than borrowing strategically. Debt can be a lever for growth, agility, and profitability.

I have a couple of book recommendations for you on this topic. The first one is Finance Your Own Business, Get on the Financing Fast Track. And this one is by Garrett Sutton and Jerry Detweiler. Jerry Detweiler has been a guest several times on this podcast and she's an expert on financing and debt

A great quote from that book that I think applies here is, quote, you can get money when you don't need it, but it's hard to get money when you do, end quote. And so what that speaks to is that there is money available if you've got the credit worthiness and if your business is credit worthy to help you start and grow a business. But if your business is not profitable,

or you're hurting, you're on a downward spiral, the only money you're gonna be able to get is high interest money, which is bad debt. So make sure that you fund your business properly and that you're ready if you're starting a business, that you're credit worthy so that you can get the best debt possible. The other book recommendation is The Growth Dilemma, Determining Your Entrepreneurial Type to Find Your Financing Comforts.

zone. So those are two books. I'll have those on the show notes page at thehowabusiness.com for this episode. Remember to go there as well to download the free checklist, Smart Business Borrowing Checklist, to help you with making a decision and evaluating the risk and the strategic effectiveness of borrowing in your small business.

This is Henry Lopez, and thanks for joining me for this episode of The Howa Business. I wish you the best as you start and grow your successful and profitable small business. I release new episodes every Monday morning, and you can find the show anywhere you listen to podcasts, including The Howa Business YouTube channel and at my website, thehowabusiness.com. Thanks for listening.

Thank you for listening to The How of Business. For more information about our coaching programs, online courses, show notes pages, links, and other resources, please visit thehowofbusiness.com.