Good Uses vs. Bad Uses of Debt: Knowing the Difference

At some point or another, most of us have had a relationship with debt. That first credit card we got in college or the mortgage to buy our current home. Sometimes the debt is used for good; other times the debt wasn’t in our best interest. (Maybe some of those early credit card purchases weren’t the best idea.)

I don’t want to sound polarizing, but there’s a good time and a bad time to use debt. That’s true in your personal finances and in your business.

So how do you know when using debt is a good thing and when you should plan to use cash?

When in Doubt, Use Caution

And when it comes to debt, there should always be a little bit of doubt because there are no guarantees. So take it slow before you dive in with a big chunk of debt.

One of our team members started a side hustle leasing heavy equipment. He and his partner paid cash for the first piece of equipment to create a proof of concept. They wanted to try out the business idea, create systems around it, and see if it had wings.

Buying one trailer as their sole rental for a bit made sense. Too much inventory would have created logistical challenges since this was a new business model. And if it didn’t work, the last thing they would have wanted was to have a bunch of heavy equipment they needed to unload–at a loss and while making monthly payments. Plus, being a new business, they need to build demand so nothing will sit idle!

When they know the model works, they can slowly add to their fleet as demand increases. And no sooner.

This is a good use of debt. Pay cash to start, then scale with well-thought-out debt when you know the concept will turn profitable.

Practice Patience and Delayed Gratification

When the government offered up the Economic Injury Disaster Loan Program, many business owners jumped on board and applied. For good reason, too, since wellness businesses were severely impacted by COVID.

But rather than use the loans as a rainy day fund to use in emergencies, we saw a lot of people using the money to lease out new spaces, buy new equipment, and invest in other ways.

We love the idea of investing in your business, but this may not have been a good use of debt for most. Most EIDL loans must be repaid. So while the loan was easy to get, you’ll still be paying on it for years to come. And though the interest rate may be low, it will add up over time.

If there’s something you want in your business, practice some patience. Create an advanced Profit First account for the investment and start setting aside a percentage of your revenue every time you do a distribution. Save at least half of the cost, then decide if incurring debt for the rest of the purchase is worth the potential return.

Keep “Potential” in Mind

As we mentioned earlier, there are no guarantees in life. Except taxes. You don’t know for sure that your business will weather the next storm. You don’t know that your next big business idea will succeed. You don’t know anything for sure. So when you’re weighing whether to go into debt for something, err on the side of caution.

Caution is all about needs versus wants. If your business is doing well and you’re finding that a specific piece of equipment is always in use, it might be time to buy another one. Especially if not having availability is limiting your ability to earn money. For example, your dance studio’s classes are continually booked out with a long waiting list. It might be time to open a new location or find a larger studio space to increase the number of people you can serve.

And if your business is moving in that direction or you’d like to grow in the future, may we suggest that advanced account right now? It’s never too early to start saving!

If you’re new to Profit First and need help getting your accounts started up, grab our Profit First Overview, which will walk you through how to get started.

Shannon Simmons

Shannon has been consulting with small businesses for over 10 years. After 2 years in public accounting she saw a need to work for small business owners to teach them how to grow financially healthy businesses. She has built on her Master of Accountancy degree from Manchester University by becoming a Certified Profit First Professional and a Certified QuickBooks ProAdvisor. When she’s not meeting with entrepreneurs or assessing their businesses, she enjoys time with her husband and 2 children serving in their community, playing and watching sports, marveling at nature or reading a good book.

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