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Good vs. Bad Debt

Guest post by: Stefan Doering

Article Overview: Many entrepreneurs get into financial trouble by not fully understanding when and how to borrow. Learn how to take on only good debt and get out of bad debt. And save a lot of money in expensive mistakes.

Good vs. Bad Debt

I was dreading making the call. I had spent about a month thinking and wondering what to say.

In all that time I came up with nothing, and I was out of time.

So I dialed.

After several rings a man answered. He did not sound pleasant or in the mood to chat. Which made me even more nervous.

I told him who I was and why I was calling. I owed the New York State a large sum of money in past-due payroll taxes.

He didn't say anything.

I told him I had just taken my company into bankruptcy, laid off 15 employees, lost almost $2 million and had absolutely nothing left to pay the State.

What I didn’t tell him was while I still owed almost $250,000 that I personally guaranteed from the now bankrupt business, I was most nervous about this debt. Mainly because there were very few things that would follow me to the ends of the earth-- whether I filed for personal bankruptcy or not-- and that was past-due payroll taxes!

I knew would not get out of this one.

The man on the line looked at my account and told me I owed almost $30,000 and plus a rapidly growing amount in penalties.

In a hard and commanding voice he asked what I would do to take care of this debt.

And in that moment I finally had an idea. I had nothing to lose, so I said, "Sir, I can do one of two things: I can pay you monthly and it will probably take many years to make this debt go away. Or I can speak with some friends and relatives about getting a loan for a part of this debt. But whatever I could get, it would have to pay this debt off in full. Because I could not afford to continue paying the State and the loan simultaneously."

He told me to call him back with an amount and we would discuss it.

But after speaking with friends and relatives I was sure my offer to the State employee was going to be a deal breaker. I got Mr. Hard Nose back on the phone and told him the amount: $7,000.

The gruff man immediately told me I had a deal. I almost dropped the phone!

The year was 1998. And I just learned a very hard lesson on the difference between good and bad debt.

One of the keys to understanding good vs. bad debt is in understanding the difference between an asset and a liability.

"An asset is anything that puts money into your pocket and a liability as anything that takes away money from your pocket." says renown American entrepreneur, writer and teacher, Robert Kiyosaki.

For example, Kiyosaki explains, buying a personal car is a liability, because it drains your cash instead of generating more of it. He continues to explain that purchasing a home is also a liability, since it takes cash to pay mortgages, maintenance, etc. It only becomes an asset when it is sold for cash.

Good Debt = borrowing cash to buy an asset.

Bad Debt = borrowing cash to pay a liability.

Sounds simple, but in business not only is it complex, it can be downright dangerous.

For example, you may borrow money on a line of credit to buy new computer equipment. You make the argument that this new equipment will generate more cash for you now.

Will it really? Or would will that equipment just be whistles and bells that won’t do anything your current equipment can do?

Unless you're in the IT world, it is more than likely it is the latter, thus making it a liability.

Multiply this decision times ten other similar decisions and you now have a more serious problem with bad debt.

Another danger zone is borrowing for "working capital". Working capital is money used to cover monthly business expenses, like rent, payroll, consulting fees, etc. In most cases, this is considered borrowing for a liability.

This is the reason few, if any lending institutions will lend to cover working capital.

How to Avoid or Fix Excessive (Bad) Debt:

· Know Your Numbers—The vast majority of the many entrepreneurs I have worked with that have debt challenges claim to "not be numbers people.” If this is you, you MUST get this handled!

· Invest Wisely-- Get clear on what are your business assets and liabilities. Is taking on additional debt to purchase something really going to generate more business?

· Use Only What is Yours— Don’t use your payroll tax money, for example. Instead, pretend you don't have it. Find another way or don’t go that direction.

· Borrow Wisely— Only borrow what you know you can repay. Be careful with, “Well, with the money I borrow, I will increase revenue and will make the payments.“ Do a risk-assessment evaluation and only do this as a last resort.

· Don't Personally Guarantee— Banks will want you to. Some landlords will insist. My advice, resist this. It defeats the purpose of incorporating your company, in most cases. And you may end up spending years paying off your debts if you go belly up.

After those hard lessons learned from 1998, I now watch my finances like a hawk. And while I have made bad business decisions since then, I recover much, much quicker.

Not a bad lesson learned from owing a $250,000!

Action Steps for the Week:

Take a look at your financial situation. Check out your Current Ratio and Total Debt Ratio.

Current Ratio = Current (short term) Assets / Current Liabilities. Anything over "1" is good. The higher the number, the better.

Total Debt Ratio = Total Debt/Total Assets. Anything under "1" is desired. The lower the number, the better.

Once you have an answer you can reduce your bad debt, if necessary, by:

1) committing to not take on any more bad debt,

2) immediate focus on increasing revenue by X%, (determine the percent)

3) decreasing expenses by Y%, and

4) renegotiating your bad debt terms.

This takes imagination, discipline, and often times support. Support of an experienced colleague, mentor or business coach.

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Article Tags: asset, bad debt, bankruptcy, BEST Coaches Inc, business financial loss, business loans, debt, debt mistakes, debt negotiations, debt ratios, financial loans, financial trouble, fix bad debt, liability, loan mistakes, loan negotiations, loan ratios, money, Rich Dad Poor Dad, Robert Kiyosaki, Stefan Doering



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