Good debt vs bad debt in business: a plain guide

Debt is good when it pays for something that earns more than the borrowing costs you. It is bad when it covers losses, pays for things that don't bring money in, or costs so much that it eats whatever it earns. The loan paperwork looks the same either way. The difference is what the money does after it lands in your account.

A simple rule: if you can't say in one sentence how a loan will pay for itself, don't sign yet.

Key Takeaways

Debt isn't good or bad on its own

People talk about debt as if it were a character flaw. It isn't. Plenty of sound businesses borrow to start, to keep running through quiet months, and to grow. What matters is whether the borrowing has a clear job to do and whether that job brings in money.

That is also why a loan can be good for one business and bad for another. A second coffee machine suits a café with a queue out the door at 8am. It does not suit a café that is quiet all morning.

There is no magic amount of debt that is "safe" for everyone either. What matters is whether you can comfortably make the repayments today, and still make them if things go wrong. If you only just scrape through each month, you have no room for a slow winter, a broken fridge or a customer who pays late.

What good debt looks like

Good debt is tied to how your business actually earns money. Here are everyday cases.

The café. You're turning customers away at the morning rush because one machine can't keep up. You borrow for a second machine. More coffees go out, and the extra profit pays the repayments with something left over.

The builder or joiner. You buy a machine that does in a day what used to take two people three days. Your labour cost drops, you can take on more jobs, and the equipment keeps working for years. This is the classic case for borrowing. The equipment pays for itself in saved wages and extra work.

The shop. You've tested a new product line and it sells. You borrow to buy stock in bulk, or to open a second shop, because you have a plan and some evidence behind it. These activities may need borrowing, but they are investments that should pay off down the line.

The timing gap. You do the work in March and the customer pays in April, but wages and suppliers are due in March. An overdraft, which lets you spend a bit more than you have in the account for a while, can bridge that gap. For a business with a genuine timing problem, it can be a flexible and affordable way to do it. If you want more detail, our guide to working capital loans covers how short-term funding for day-to-day cash works.

A worked example of good debt

Imagine a café borrows to buy a second coffee machine. These numbers are made up to show the thinking, not quotes from any lender:

• The loan costs $500 a month to repay, interest included.
• The extra coffees add $1,500 a month in sales. After milk, beans, cups and a bit of extra wages, about $800 a month is left as extra profit.
• That is $800 coming in against $500 going out. The machine pays for itself and leaves $300 a month over.

Now flip it. If the extra coffees only leave $400 a month in profit, the same loan costs you $100 a month more than it earns. It's the same machine and the same loan, but now it's bad debt.

So the test is not "is this a sensible purchase?" It is "does it earn more than it costs me, month after month, even in a quiet month?"

What bad debt looks like

Bad debt comes in a few forms, and most of them are easy to spot once you know to look.

• Borrowing to cover losses. If the business is losing money and you borrow to keep the doors open, you haven't fixed anything. You've added a repayment on top of the loss.
• Borrowing for work that isn't profitable. Taking on debt to support jobs or products that don't make money creates ongoing pressure. The same goes for chasing work where payment is uncertain.
• Buying things you don't really use. An asset that sits in the corner or doesn't help the business perform will drain your cashflow and leave you with less room to move.
• Vehicles the business can't afford. An expensive ute or van bought on finance is one of the most common ways small businesses get into trouble. A vehicle can be a perfectly good tool, but only if the business can carry the repayments.
• Paying the owner's lifestyle. A holiday, a second car or personal spending funded from the business adds to the debt without adding to the income. Make it a firm rule not to dip into the business to pay for your personal life.
• High-interest borrowing. Expensive lending can quickly drive up your costs and make the debt harder to manage. If you can avoid the highest-priced lenders, do.

Bad debt also tends to breed more bad debt. Once you borrow to pay a bill, the repayment becomes the next bill, and you can end up borrowing again to pay it.

Is borrowing to cover a gap always bad?

No, and this is where many owners get tangled up.

Borrowing to cover a short, known gap can be sensible. A customer is late paying. A van is off the road after an accident and needs replacing. You lost a contract and need a few months of breathing space while you win new work. The borrowing gives you time, and you can see how it ends.

Borrowing to cover a gap that never closes is the problem. If you borrow every month just to pay wages, rent or suppliers, the loan isn't bridging anything. It's hiding a business that costs more to run than it brings in.

A fair question to ask yourself: what has to happen for this loan to be paid off, and how likely is that? If the answer is "the customer pays the invoice next week", that's a bridge. If the answer is "business picks up, I hope", be careful.

One point where we'd be blunt: if you are regularly borrowing just to pay everyday costs because customers pay late, fix the late payment first. That is the problem, and the loan is only a bandage.

Why expensive short-term borrowing hurts more than it looks

Short-term borrowing often feels cheap because the amount is small and the repayment period is short. The sums can still be large once you work out the yearly cost.

Here is a simple, made-up example. It's not a quote from any lender, just a way to show the arithmetic:

• You borrow $10,000 and the lender asks you to pay back $12,000 after three months.
• The extra is $2,000, which is 20% of what you borrowed. That is 20% for three months.
• There are four lots of three months in a year. If you did the same thing four times, the cost would be 4 × 20% = 80% a year.

No one would sign up for a plain 80% a year loan if it were put that way. Cutting the time into a short period makes the cost sound small.

So with any short-term offer, ask for these three things in writing:

1. The total dollars you will pay back, not just the weekly or monthly amount.
2. The total cost (everything over and above what you borrowed, including fees).
3. What happens if you need to borrow again next month.

Fees and pricing differ from one lender to the next, so compare the all-in cost and not just the headline number. Our guide to unsecured business loans explains how that kind of borrowing is priced.

Expensive short-term borrowing can still be worth it in a narrow case. That is when you know exactly how the money comes back (a signed order, an invoice from a reliable customer) and the profit on the job is bigger than the cost. For most small businesses, we would not use it to pay general bills.

Tax debt is bad debt too

Many owners don't think of money owed to IRD as borrowing, but it behaves like it. Overdue GST and income tax attract interest, and the bills arrive on set dates. Provisional tax, GST and terminal tax all come due, and owners who haven't saved for them often end up owing.

If you're in that position, one sensible move is to look for a loan that costs less than the interest IRD charges, and use it to clear the tax debt. The current IRD rate changes, so check it before you compare. Only do this if the new loan is truly cheaper and you can keep up the repayments.

A better fix is to avoid the problem in the first place. Put a slice of each sale aside for tax as you go, in a separate account if you can.

How much debt is too much?

There isn't a number. Ask yourself these instead:

• Can my business comfortably afford the repayments?
• Would I still manage them if sales dropped?
• Will this borrowing bring in money, save money or help me grow?
• Have I looked at other ways to fund it?
• Do I know the full cost of the borrowing?

If you answer "no" or "not sure" to the first two, the debt is probably too much, however good the purchase looks.

Heavy debt also has quieter costs. Repayments eat cashflow, so you have less to reinvest in equipment or stock. Money gets pulled away from the parts of the business that make it better, and quality can slip. The stress is real too, and it affects your decisions at work and at home.

How to get out of bad debt

There's no single trick, but this order works for most small businesses.

1. Find out why you're in debt. Is it late-paying customers, tax not set aside, a vehicle you can't afford, or the business simply isn't making enough? The fix depends on the cause.

2. Sort out your terms of trade. This just means the conditions you set for customers. Ask for a deposit or upfront payment. Run a credit check on new clients. Chase unpaid invoices quickly, and don't wait 60, 90 or 120 days to get paid. Customers who know and like you are also less likely to become slow payers.

3. Cut costs, carefully. Go through your regular bills: internet, phone, subscriptions, even the Christmas function. Use the savings for repayments. Just don't cut the things that make your product or service good, or you'll lose the customers who pay for the debt.

4. Stop spending the business's money on personal things. If the business is in debt, the holiday and the second car can wait. Each dollar spent on something you don't need is a dollar that could have gone towards the loan.

5. Bring in more money. Getting more customers and making more sales, while keeping costs down, is the cleanest way out of debt. Look at your marketing and your pricing.

6. Swap dear debt for cheaper debt. If you have several debts, such as credit cards, vehicle finance and a short-term loan, ask whether you can combine them into one loan at a lower rate over a longer time. The monthly payment drops, which can give you breathing space. Be aware that a longer term means paying interest for longer, and if the loan is secured against your home, you're putting your home on the line. Take any restructure to your accountant first.

7. Make a forecast. A cashflow forecast is a simple month-by-month list of the money you expect in and out. Lenders want to see forecasts, and you'll learn a lot from building one. Update it regularly, and check your results against it each month.

8. Talk to your accountant early. Don't wait and hope. Your accountant can help you draw up a plan, check how your business is set up, and show you simple measures that warn you of trouble before it arrives.

Frequently Asked Questions

Is an overdraft good or bad debt?

It can be good, if you use it for what it's made for: bridging the gap between paying your bills and getting paid by customers. It turns bad when it's permanently maxed out and you're using it to cover losses.

Can borrowing to pay wages ever be okay?

Only as a short bridge when you know where the money to repay it is coming from, such as a big invoice due soon. If it's happening every month, the business has a bigger problem than the loan can fix.

Should I borrow to pay my tax bill?

It can make sense if you can find a loan that costs less than the interest IRD charges, and you can afford the repayments. Check the current IRD rate and compare the full cost before you decide. Saving for tax as you earn is far better.

How do I know if a loan is too expensive?

Ask for the total dollars you'll pay back and the total cost over the life of the loan, then compare it with the profit the money will earn. If the loan costs more than it earns, it's too expensive for you, whatever the monthly payment looks like.

If you're weighing up a loan and can't tell which side of the line it falls on, we're happy to look at the numbers with you. Deplexifi works with small businesses across New Zealand to find borrowing that fits what the business earns. You can start at Deplexifi NZ.

Treating a loan as good because the purchase sounds sensible. What counts is whether it earns more than it costs every month, including the quiet ones.