Good debt versus bad debt - British Business Bank (2024)

FAQs

What is the difference between good debt and bad debt in business? ›

Debt can be considered “good” if it has the potential to increase your net worth or significantly enhance your life. A student loan may be considered good debt if it helps you on your career track. Bad debt is money borrowed to purchase rapidly depreciating assets or assets for consumption.

A bad debt is one that will not be paid, typically because the debtor is a company that no longer exists or isn't able to pay for some other reason.

When a business does not expect to recover a debt, the debt becomes bad and is written off. To assume a more attractive position and reduce its tax liability, banks often write off toxic loans, the most common form of bad debt for a bank.

Bad debt is an amount of money that a creditor must write off if a borrower defaults on the loans. If a creditor has a bad debt on the books, it becomes uncollectible and is recorded as a charge-off.

What's the Difference? A simple rule about debt is that if it increases your net worth or has future value, it's good debt. If it doesn't do that and you don't have cash to pay for it, it's bad debt.

The difference between good debt and bad debt is that good debt offers long-term financial benefits to you, whereas bad debt hurts your finances. Examples of good debt include mortgages that provide a home and a valuable asset and student loans that provide job skills.

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.

In 2021-22, we expect debt to be equivalent to 98.2 per cent of national income – the highest ratio since 1962-63. It is equivalent to around £2.4 trillion or £84,000 per household. We expect the ratio of net debt to national income to fall gradually over the next five years to reach 88.0 per cent in 2026-27.

A low percentage means that lenders, especially mortgage companies, will look on you more favourably, as you spend less on servicing debt and have more money available to cover any larger loans that you take out. Anything between 0% and 39%, which ranges from very low to acceptable risk, should be seen as a good DTI.

The write-off: The debt settlement company pays the lender the settled amount, clearing the debt. The lender then writes off the balance that wasn't paid for as part of the settlement offer. Keep in mind that the amount of money the lender writes off is considered income for tax purposes.

Why do bad debts need to be written off immediately? ›

In this way, the financial and accounting reports will show a fairer and truer state of affairs of the business. Bad debts if not written off would still be included under Debtors in the Balance Sheet, thereby implying that this amount is recoverable. This would be untrue and would overstate assets of the Company.

While it's highly unlikely that any credit card company will forgive 100% of your debt without it being part of a bankruptcy, you may be able to negotiate a settlement with your lenders in which they forgive a percentage of the balance you owe.

Good debt—mortgages, student loans, and business loans, steer you toward your goals. Bad debt—credit cards, predatory loans, and any loan used for a depreciating asset—steers you away from your goals. With debt, moderation is key; even good debt, when overused, can turn bad.

Bad debt can be harmful to your business, especially if it happens frequently. Not being able to collect payments when you provide a good or service can slow down your cash flow. And, it can make your business's bottom line negative. Cash flow is the money that goes in and out of your business.

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.

From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money. While a low debt ratio suggests greater creditworthiness, there is also risk associated with a company carrying too little debt.

Bad Debt Example

A retailer receives 30 days to pay Company ABC after receiving the laptops. Company ABC records the amount due as “accounts receivable” on the balance sheet and records the revenue. However, as the 30 day due date passes, Company ABC realises the retailer is not going to make the payment.

Bad debt is the amount owed to a company by a customer who cannot make payments and is typically written off as a loss.