Good debt vs bad debt for Australian small businesses

By: Kyle Prevost, a prominent personal finance writer and blogger (as well as an honoured educator), writing for publications like MoneySense (Canada’s #1 investment journal) and ValueWalk, and is providing commentary in radio and mainstream Television (Linkedin profile)

A loan's purpose is only the start of deciding whether it is useful debt. The cost, repayment dates and risk of the expected income failing to arrive matter too. A necessary purchase can still come with a loan the business cannot afford.

The business examples below test the return, timing and downside before assigning a label to the debt.

Good Debt vs Bad Debt for Small Business, Sole Traders and Companies

Again, we see that while many people appreciate the concise nature of these quick definitions, when we apply this “black and white” logic to real life, it can be much difficult to determine whether borrowed funds are good debt or bad debt at the time the loan is granted. Assets purchased with the intent of growing a business can quickly prove to be less helpful than initially anticipated. Similarly, interest rates can change quite quickly, and make what was once considered to be good debt or even great debt, terrible debt over the long term.

Limited access to finance can force a difficult choice. A higher-cost offer still needs to be affordable; rejecting it may be sensible if repayments would undermine the business. Compare the cost of the loan with alternatives such as repairing equipment, changing supplier terms or postponing the purchase.

If a machine is essential to trading, replacing it may protect revenue. But the financing details still matter. A loan that requires repayments before the machine earns enough cash can make a necessary purchase unaffordable. Compare the replacement cost, expected cash contribution and repayment schedule, including a period of weaker sales.

Business structure alone does not settle the risk. Company borrowing may involve security or a director's personal guarantee. A sole trader and a company can therefore face different obligations, but neither should assume that personal assets are protected without reading the agreement.

Trading history and reliable accounts can help a lender assess repayment capacity. They do not guarantee a lower rate or approval. The useful evidence is the business's own cash flow, existing commitments and ability to service the proposed debt.

In construction and other project-based industries, finance may be part of the operating model. That makes timing especially important: staged costs, progress payments and delayed completion must fit the repayment obligations.

Judge the project and the loan separately

A replacement machine can be essential and its proposed finance can still be unaffordable. First compare repair, replacement, rental and waiting. Then test the chosen option against the actual repayment dates, including a slow start or a breakdown. Calling the asset “productive” does not pay the instalments.

Measure the cash the purchase adds

A useful investment can increase sales without producing enough cash to meet its finance payments. Start with the additional receipts, then subtract the extra materials, labour, maintenance and other operating costs required to earn them. Use the remaining cash contribution to test the debt schedule. Turnover is the wrong denominator if most of the extra revenue immediately pays suppliers.

Consider an illustrative machine expected to add $6,000 of monthly sales. Materials and extra labour cost $3,800, maintenance adds $300 and the proposed finance payment is $1,600. The resulting cash contribution after those items is $300 a month. This calculation excludes tax and other business costs, so it does not establish the project's final profitability.

If the expected sales fall to $4,800 while variable materials and labour fall proportionately to $3,040, the same maintenance and finance payments leave a $140 monthly shortfall. The machine remains productive, but the financed project no longer pays its way under these assumptions. The point of the weaker case is to expose the margin for error before the agreement is signed.

Compare the next-best way to do the work

Put repair, rental, outsourcing and purchase beside one another. Repairing an old machine may be cheaper but leave the business exposed to further downtime. Renting may cost more per month but preserve the option to stop. Outsourcing can reduce the fixed commitment while giving up control over timing or margin. The tradeoff depends on how certain the demand is and how damaging interruption would be.

Include costs that remain if the project stops. A lease payment, guarantee or minimum supplier commitment may outlast the work that justified it. Ask what could be sold, cancelled or reduced and how quickly. A resale estimate should allow for the possibility of a hurried sale, rather than assuming the equipment recovers its purchase price.

Growth can absorb cash before it produces it

A larger customer order may require more stock and wages before payment. Even a profitable sale can therefore increase the peak funding need. Model the old business and the new order together: existing customers still need service and existing creditors still require payment while the new work is under way.

The government funding guide distinguishes borrowing from equity and includes trade credit and other routes. That distinction matters where returns are uncertain or take a long time to arrive. A commitment with fixed repayments needs a cash source while the project is still developing.

Preserve room for the next necessary decision

Assess the new debt with every existing facility, not as an isolated approval. It may use security or cash that would otherwise support a replacement vehicle, seasonal stock or an unexpected repair. Keeping some capacity unused has a cost if it delays profitable work, but it also gives the business choices when the forecast changes.

Record the decision in a short investment case: amount committed, repayment source, weaker-case result, alternative considered and a date to review performance. Compare actual cash contribution with the forecast after the asset or project begins operating. If the case is deteriorating, acting early gives more options than waiting until a missed payment forces the decision.

Working with debt in your business

1. Name the repayment source. Is it cash from an existing customer, a recurring operating surplus or an untested sales forecast?
2. Compare total costs. Include mandatory fees, payment frequency and any early-repayment charges, not just the quoted rate.
3. Test the timing. Delay the expected income and check whether the business can still meet wages, tax and debt payments.
4. Read the personal obligations. Security and guarantees can change who bears the loss if the plan fails.
5. Check the alternative. Repairing, renting, waiting or negotiating payment terms may achieve the same purpose with less debt.

A short-term facility can cover a defined cash gap. It is not essential for every business and should not be treated as a permanent solution to recurring losses. The rate-comparison guide explains how to put different quotes on a common basis.

Before you make the commitment

Write down the expected cash contribution, the dates it arrives and the costs that continue if the project disappoints. Put the loan schedule alongside them. If the case depends on immediate full capacity, an easy refinance or a sale price that has not been tested, reduce the commitment before signing.