Business debt - good vs bad business debt explained

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 SMEs hold 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, the BoE'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 programme that 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 the different 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 as export finance and business 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 learn what 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 our guide to dealing with debt.