The economic impact of Covid-19, soaring inflation and interest rates, along with cash flow challenges linked to supply chain constraints have led to a surge in smaller business borrowing.
According to the Bank of England (BoE),one-third of SMEshold debt levels more than ten times their cash balances, compared to just 14% pre-Covid.
Unmanageable debt can be damaging for smaller businesses.
With UK Government Covid-19 support schemes wrapped up, theBoE's Financial Policy Committee (FPC)has predicted that business insolvencies are expected to increase from historically low levels.
Yet not all debt is bad.
Managed and serviced correctly, debt can provide a cash injection that can help businesses grow, expand into new markets, invest in new technology, or acquire other enterprises.
Debt is an integral part of the business lifecycle.
Debt can be used to launch a new venture, such as through the British Business Bank’s Start Up Loans programmethat provided £126 million in funding (PDF, 8.8. MB)in 2020, through to investing in and scaling established businesses.
The challenge for smaller businesses, especially against the backdrop of increased costs, is tied to unplanned or poorly managed debt.
Outstanding customer payments, unexpected capital costs such as plant or equipment repairs or replacements, and pressures on overheads such as salaries can see businesses take on expensive short-term loans or be unable to repay existing debts.
Good debt vs bad debt
Understanding the difference between 'good' and 'bad' debt can help your smaller business's financial planning and ensure that debt is used actively for growth rather than reactively to tackle problems.
Read our guide to thedifferent types of external finance for your business.
What is good debt?
A healthy level of debt supports business growth and helps smaller businesses expand their market share.
Good debt is usually planned with a clear purpose for investing.
It is generally linked to a return on that investment, such as buying new equipment to increase production and meet growing customer demand or investing in R&D.
Good debt is also tied to who is lending your business money, the type of loan, and the loan’s interest rate.
Low-interest rate loans from reputable lenders, for example, may be considered good debt.
The level and type of debt your customers accumulate can also be good or bad.
Good debt is where customers buy your services but make regular, consistent repayments in line with their agreement with your business.
Examples of good debt
- low-interest business loans with manageable repayments
- growth finance, such asexport financeandbusiness loans.
Tips for managing good debt
- For businesses– create a financial forecast for taking on debt, including repayments and how debt will be invested, along with forecast growth such as increased revenues or greater profits after deducting debt repayments.
- For customers– encourage your customers to set up standing orders for payments and incentivise regular payments with discounts on services or products.
Read our guide to learnwhat level of debt is healthy for a business.
What is bad debt?
Business customers are a significant source of bad debt.
Bad debt owed to your business is debt that technically cannot be recovered, such as your customer becoming insolvent.
Writing off bad debt from a customer can have a significant impact on cash flow, leading you not to be able to service your debts.
Bad debt also refers to an amount your business owes a creditor that is difficult to repay.
Unexpected costs can drive it and bad debt can come in the form of short-term, high-interest loans to cover cash shortfalls, for example.
It can be unplanned and is often a survival tactic that enables a business to keep trading during cash flow constraints.
Examples of bad debt
- overextended customer credit lines
- customers unable to pay back their debt to you, such as through insolvency
- debt you can’t pay back due to lack of business liquidity
- unplanned high-interest loans, such as emergency overdrafts.
Tips for managing bad debt
- For businesses– Ensure professional financial planning and budget management and consider using services such as factoring companies for invoicing finance to maintain cash flow so you can meet your debt repayments.
- For customers– Write off bad debts from customers so they are tax-deductible and you can reclaim tax such as VAT. Consider using debt collection agencies or small claims courts to recover bad debts from customers if they are still trading.
Read ourguide to dealing with debt.
Reference to any organisation, business and event on this page does not constitute an endorsem*nt or recommendation from the British Business Bank or the UK Government. Whilst we make reasonable efforts to keep the information on this page up to date, we do not guarantee or warrant (implied or otherwise) that it is current, accurate or complete. The information is intended for general information purposes only and does not take into account your personal situation, nor does it constitute legal, financial, tax or other professional advice. You should always consider whether the information is applicable to your particular circ*mstances and, where appropriate, seek professional or specialist advice or support.
FAQs
Good debt is also tied to who is lending your business money, the type of loan, and the loan's interest rate. Low-interest rate loans from reputable lenders, for example, may be considered good debt. The level and type of debt your customers accumulate can also be good or bad.
What is the difference between good debt and bad debt in business? ›
For most people, the word "debt" has negative connotations. However, especially when starting a small business, you don't need to avoid debt altogether. There is "good debt" that is necessary for growth when launching a business, and there is “bad” debt that could have long-term negative consequences for your finances.
What is a business bad debt? ›
Business bad debts - Generally, a business bad debt is a loss from the worthlessness of a debt that was either created or acquired in a trade or business or closely related to your trade or business when it became partly to totally worthless.
Is a business loan good debt? ›
Business debt in the form of a loan is but one tool in a company's financial arsenal. It's crucial to distinguish between “good debt” and “bad debt.” Capital at the company's disposal that can be used as an investment that will generate long-term income or grow in value is “good” debt.
Why is debt good for a business? ›
Businesses use debt to improve cash flow, pay suppliers, run payroll and more. Taking loans or seeking financing can be part of a business growth mindset.
What is good vs bad debt examples? ›
Good debt—mortgages, student loans, and business loans, steer you toward your goals. Bad debt—credit cards, predatory loans, and any loan used for a depreciating asset—steers you away from your goals. With debt, moderation is key; even good debt, when overused, can turn bad.
How do you recognize the difference between good and bad debt? ›
It might be considered good debt if you get a low interest rate and use the loan to purchase a primary vehicle. But it might be considered bad debt if you're borrowing money to buy a second car or a boat, and the loan payments make covering your day-to-day expenses difficult.
Why should you never pay a charge off? ›
Your credit could be damaged for seven years.
Missed payments, charge-offs and collections remain on your credit report for seven years. Their mention on your credit reports and their effect on your credit scores could impact your ability to get new credit in the future, though their effect diminishes over time.
What is bad debt for business in one word? ›
Bad debt is debt that cannot be collected. It is a part of operating a business if that company allows customers to use credit for purchases. Bad debt is accounted for by crediting a contra asset account and debiting a bad expense account, which reduces the accounts receivable.
What qualifies as a non business bad debt? ›
A nonbusiness bad debt is any debt other than one created or acquired in connection with the taxpayer's trade or business, or one that, when worthless, creates a loss that is incurred in the taxpayer's trade or business.
Key Takeaways. Whether or not a debt ratio is "good" depends on contextual factors, including the company's industrial sector, the prevailing interest rate, and more. Investors usually look for a company to have a debt ratio between 0.3 (30%) and 0.6 (60%).
How much debt is too much for a small business? ›
If your business debt exceeds 30 percent of your business capital, this is another signal you're carrying too much debt. The best accounting software can help you track your business debt, manage your cash flow, and better understand your business' financial situation.
Does business debt affect personal? ›
Business debt, therefore, is essentially considered personal debt, and will affect your personal credit accordingly. Moreover, this debt is not directly tied to your company, meaning you will be responsible for repayments, whether your company succeeds or not.
How does bad debt impact a business? ›
Bad debts are not good for a business. While one or two bad debt expenses of small amounts may not make much of an impact, large debts or several unpaid accounts may lead to significant loss and even increase a company's risk of bankruptcy.
What does business debt mean? ›
Business debt means a bona fide loan or debt made for a business purpose that both parties intended be repaid.
What is classed as bad debt? ›
Bad debt is money that is owed to the company but is unlikely to be paid. It represents the outstanding balances of a company that are believed to be uncollectible. Customers may refuse to pay on time due to negligence, financial crisis, or bankruptcy.
What does good debt mean in accounting? ›
Low-interest rate loans from reputable lenders, for example, may be considered good debt. The level and type of debt your customers accumulate can also be good or bad. Good debt is where customers buy your services but make regular, consistent repayments in line with their agreement with your business.
Is bad debt a loss or profit? ›
Technically, "bad debt" is classified as an expense. It is reported along with other selling, general, and administrative costs. In either case, bad debt represents a reduction in net income, so in many ways, bad debt has characteristics of both an expense and a loss account.
Is bad debt positive or negative? ›
Debt could also be considered "bad" when it negatively impacts credit scores -- when you carry a lot of debt or when you're using much of the credit available to you (a high debt to credit ratio). Credit cards, particularly cards with a high interest rate, are a typical example.
What is the meaning of bad debt? ›
Bad debt meaning
Simply put, a bad debt is a type of expense that occurs after repayment by a customer (when credit has been extended) is no longer considered to be collectable. In other words, bad debt is an irrecoverable receivable.
