Debt: "good" vs "bad"

I was at a seminar recently on managing money and the financial planner on the panel talked about how debt can sometimes be good, and sometimes bad, without providing any context on what the difference may be. Not helpful!

As an adult in a western culture, it's very rare to have no debt. It may be university fees you need to pay back over time, buying a car, the biggest one is usually property. Credit card debt is something that gets a lot of press as well. 

Japanese families never used to have credit cards, hence the level of household spending was a key economic measure that was rigorously tracked and analysed as a sign of economic health. While the use of credit cards has grown in Japan, many shops still don't accept them, hence a trip to the ATM at the airport in Tokyo to get some cash is an essential part of travelling to Japan. 

Many businesses use debt as a way of funding their growth as well. For many SME owners, personal and business debt are interlinked so I've covered both of them here. 

To understand whether debt is either good or bad in any given situation, there are 3 questions you need to ask yourself:

1. Are you investing in something now that will create something far more valuable than the debt over time. 

This is the primary argument for a property mortgage. The assumption is that property prices will rise, hence your property will be worth more than the mortgage. 

More than one property developer has got in trouble with this one. This is because they borrow to build the property, then sell it later. They pay interest in between borrowing & selling. This increases how much they owe. The property market can also turn down during this time, leaving them in a hole. 

University debt is less tangible, the idea is that you will earn more over time than you would have without it. That's why a lot of govt based programs around the world take it out of your salary once you earn a certain amount. Some of the coming changes in technology may challenge this assumption. 

From a business viewpoint, the most effective debt instrument I've seen for service based (rather than asset based) businesses is a loan against your receivables balance (the amount of money customers owe you). Most services based businesses with receivables ledgers take up to 60 days to collect the money, with all salaries and other employee related costs paid monthly when the work is done. I've used that before to free up cash to make investments in the business to grow the revenue. We monitor the cashflow forecast very carefully to make sure the business is generating free cashflow. 

This is where a lot of people trip up on credit card debt - it's spent on consumables which don't have future (economic) value. If you pay it off every month, it's a useful tool. If you pay the minimum, you're a bank's best customer - they make a lot of money in interest from you! This is why most personal finance programs start with paying off your credit card debt. 

2. All debt has to be paid back at some point. Always. Can you afford to pay it back. 

Whatever way it's sliced, debt has to be paid back at some point. The exception to this is those who declare themselves bankrupt - going into debt assuming this is an option will have knock on consequences (stomach ulcers spring to mind........). 

For a business owner, this is particularly relevant. Can your business pay the debt back out of surplus profits. 

Many business owners can't get a loan based on the merits of a business case - often the only option is to mortgage a property (see above). There's several factors within the inner workings of how banks look at risk which drive this which are not going to change anytime soon. 

If this is you, the question you need to ask yourself is whether you have the confidence the investment you're making in your business will generate sufficient surplus cashflow to pay back the debt. If you are, then a mortgage on your property is a cheaper option for you than just about any other funding source.  

Using the example above with a loan against receivables, this business is in growth mode hence surplus profits need to be re-invested. Once they get to the point that their profit % is a healthy number and they can absorb up to 60 days for customers to pay, the facility will run down to zero and it'll get removed. 

3. If your circumstances change, is there enough flexibility to change your debt (slow down repayments, sell an asset & pay it off). 

In asset based businesses, there is a rule during an economic downturn - sell under performing assets (even if it's at a loss) and pay down debt. 

I used this rule personally during the global financial crisis - I sold an investment property and paid down the mortgage. While I had to drop the price, I have never regretted that choice. 

From a business context, lets say you have a business loan for an investment that will increase revenue or profits. Let's say those don't come to pass. Can you restructure (usually this means pulling back) on those investments and pay the loan off. 

If you can get your business into a position where the underlying business is generating profits (even if that does mean pulling back), you are in a much stronger position to negotiate a repayment plan with your lender.

 

There have been times in history that relations with lenders have got pretty fraught (such as the GFC) and many business owners are very reluctant to go anywhere near a bank, and with good reason. If this is you, your answer is yes to all 3 questions, and you're holding back on investing in your business due to this concern, it may be time to look at a few alternatives.