In his best selling series Robert Kiyasoki makes a distinction between “good” debt and “bad” debt. As he defines it, good debt is that in which the debt is used to generate a positive cash flow. Application of this definition results in the elimination of personal debt as good debt. Some error in believing that all business debt is good debt.
But is any debt, even business debt, really good? Thhis article addresses three arguments frequently used to justify business debt. (1) Interest on business loans is deductible from the taxes of a business. (2) A mix of equity and debt is a prudent business decision and expected by lenders/investors. (3) Businesses in the early stages of growth don’t have an option but to incure debt. Let’s examine each of these arguments.
(1) Interest on business loans is tax deductible. Some seem to think that the interest deduction essentially means free money. Suppose you pay $10,000 in interest during the year for a business loan. Let’s assume the business is a S-Corp or LLC and that the net income from business operations passes through to the owner. With the loan, the income from the business is $10,000 less then without the loan. If the owner is in the 35% tax bracket, the tax deduction is only $3,500. In order to take advantage of the interest deduction, the owner paid $6,500 for the privalege. So is it really prudent to pay $6,500 to write off $3,500. Ah, let me think.
(2) A mix of equity (ownership) and debt is prudent and expected by lenders. If you were a lender and approached by a business owner for a loan, would you really be excited that other lenders had precidence over you? As a lender would you rather lend to a business that had no debt or one that had 50% equity and 50% debt. In the first instance, should the business default on the loan you as the lender are first in line to attempt to recover the unpaid amount. In the second case, all other lenders stand ahead of you. You my not recover any or all of the amount owed. Which position would you prefer to be in?
(3) Businesses in the early stages of growth don’t have a choice but to incur debt. While I don’t deny that obtaining necessary capital is difficult during the early stages of growth, I believe too many business owners seek the easy path by incurring debt rather than agressively seeking out investors. SBA loan guarantees have reduced / almost eliminated the risk to lenders and thus have made it considerably easier to obtain a loan. Business owners are also attracted to debt because the lender doesn’t expect to have some degree of ownership in the business. What owners often forget is that there are required payments that must be paid on time. In contrast, partial ownership doesn’t mean required payments nor that there is any involvement in daily business operation by the investor. In a young business, isn’t it better to remove as many required cash outlays as possible.
So, ith there good debt? The intent os this article is to suggest that no debt is good debt. What do you think?