What entrepreneurs need to know about good vs bad debt

Most businesses will need to take on debt at some stage or another, but certain debt should be avoided, writes Pure Capital co-founder Sam Roby. He breaks down good and bad debt and outlines how you can steer clear of the negative form.

The actions behind the Reserve Bank of Australia has a waterfall effect on Australia’s financial growth, employment and overall living standards. It impacts each Australian immensely as we all harbour a form of debt.

The usefulness of debt has been a grey area across Australia for many decades. This especially hinders entrepreneurs from turning their vision into a reality, and when you throw in the idea of ‘good debt’ and ‘bad debt’ it’s even more confusing.

So it begs the question…what’s the difference?

Good Debt

The idea of ‘good debt’ correlates to Australian businesses obtaining leverage to scale their valuations and hopefully improve their bottom line. The fastest way to obtain leverage is through borrowing. Good borrowing relates to using money to increase productivity and grow faster than you otherwise could.

The easiest and most common way to show this in action is when you get a mortgage to buy a property. Ordinarily the rate of growth of property outstrips the average person’s ability to save. So without debt, it would be almost impossible to buy. Instead, by using financing you can access the market much faster, and take advantage of a multitude of asset enriching schemes such as capital gains.

This can also be done in businesses that provide goods by accessing facilities like small business loans or lines of credit. It is important to weigh up what the debt will cost in monetary terms versus the outcome of using that money.

Say you are in the fashion industry and you need money to get stock through the door. By borrowing the money you need, you can gain more purchasing power and drive your costs down. That’s because you can buy in bulk rather than limit yourself to the funds you have in the bank.

Bad Debt

On the other hand, bad borrowing usually correlates to luxury purchases. There are really only two types of people who borrow money for luxury purchases: those who have the money but want to use it elsewhere, and those who don’t have the money.

Let’s say you have $500,000 invested in the stock market that was returning you an average of 10 per cent per year and you decide you want to purchase a luxury vehicle. Your two options would be to finance the vehicle at a rate of 5 per cent per annum, or sell some of your shares and pay cash for the vehicle.

If you chose to sell the shares, you are potentially short changing yourself 5 per cent per year in returns. In which case financing would be a good debt.

Whereas if you don’t have the money and borrow, you could limit your opportunities and your cash flow for other income generating assets, so this may be considered bad debt.

Credit card debt usually falls into the ‘bad’ category, depending on what you are buying. Especially if you are an entrepreneur who is early in their career and trying to maintain appearances by spending money you don’t have.

Every time you make a move to borrow money, you must think about the long term implications.