When it comes to growing your business, it’s important to differentiate the different types of debt. Saying all debt is bad is an oversimplification and could limit your growth potential.
Restricted cash flow is not only frustrating, but it can also be devastating to the success of your business. That’s why it’s helpful to identify the three different types of debt: good, bad, and ugly.
Good debt is tied to a positive Return on Investment “ROI”. This means the cost of the loan or investment costs less than the value you get out of it. For example, if you take out a loan that totals $20,000 for a business opportunity that increases sales by $60,000, that’s a good investment using good debt well.
Bad debt is any debt that costs more than you get out of it, also known as negative ROI. For example, if you take out a loan that totals $20,000 for a business opportunity that increases sales by $10,000, that’s a bad investment. [Note: We’re not referring to bad debt in the accounting sense, which is accounts receivable that will not be collected for whatever reason.]
Bad debt is often taken on to cover sudden expenses or to purchase items that rapidly lose their value. Good debt can also turn bad if the debtor has no strategy to pay it off. You can help prevent good debt from becoming bad debt by estimating the potential ROI ahead of time.
Ugly debt is bad debt that’s run out of control and into the hands of debt collectors. Obviously, good debt can turn bad and then become ugly – and quickly too. An overdue invoice can quickly spiral out of control to the point of incessant phone calls from debt collectors asking for the original debt plus their administrative fees, and interest.
The key to squashing ugly debt is addressing bad debt early on. If you estimate the ROI of an investment, calculate a conservative timeline and plan for how you will repay your loan, you can avoid taking on bad debt. If your debt does turn bad, ensure you contact the lender early – before you default on repayments – and set up a payment plan. This will save you a lot of stress and potentially a lot of money in dishonour penalties.
Why Bother Calculating ROI?
Return on investment (ROI) measures investment performance. It calculates the profit as a percentage of the initial investment amount. A positive ROI means you will make more money than you invested. ROI can be the critical difference between ugly debt and positive growth.
Running a business is exhausting, so why should you take time out of your over-packed schedule to dredge up your high school maths knowledge? Because ROI can give you a precious insight into the potential return from your risk. Calculating the ROI on a business loan can indicate how much growth opportunity lies ahead.
Risk Versus Return
It can be difficult to account for risk when calculating ROI. But if you haven’t calculated the total cost of your investment and the potential profit, how can you tell whether the risk is worth the gamble? Risk appetite is highly personal and you need to make a decision that’s right for your business circumstances.
Having working capital can let you take advantage of the less risky investments like buying a bulk order to take advantage of economies of scale or seasonal discounts. Restricted cash flow can make it difficult to produce working capital upfront, and that’s where a business loan can help your business grow.
Calculating ROI is quite simple. The hardest part is estimating the net profit you stand to make from your investment. The formula is: ROI (%) = (Net profit / Investment) x 100. The answer is the percentage of your initial investment and this result is very handy for businesses and investors alike.
Remember, calculating ROI might just be the difference between taking on ugly debt and taking your business growth to the next level.