The following excerpt is from Mark J. Kohler and Randall A. Luebke’s book The Business Owner’s Guide to Financial Freedom. Buy it now from Amazon | Barnes & Noble | iTunes | IndieBound
As an entrepreneur, it’s important to know the difference between good debt and bad debt. Good debt comes in the form of loans, a mortgage or lines of credit that can be used to the company’s benefit. I call this productive debt.
Bad debt, for our purposes, is debt you can’t leverage when growing your business. I refer to this as reductive debt. It’s money that isn’t working for you in any productive way. Typically, it’s used to buy things you can’t really afford; when that happens, it will never produce a good outcome.
I believe there are three primary reasons entrepreneurs get into bad debt:
1. The ups and downs of cash flow. When the cash is rolling in, there isn’t anything more exhilarating. However, business owners often underestimate the dramatic ups and downs and don’t foresee the months of terrible cash flow. We turn to credit cards to smooth out the ups and downs of cash flows so we can provide some type of economic balance in our personal life. We also presume we can easily pay off the credit card next month, but we don’t. Thus, the crisis begins.
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2. Putting too much pressure on our business. Many times, an entrepreneur will start trying to live on the income from their business before their business is able to sustain them. They quit their day jobs and work hard to build the businesses, but they don’t realize they’re just not ready to pay the monthly salary they need to live on. The business needs reinvestment and time to mature. It needs reserves and time to create consistent cash flow. Maintain a second job or another income in your family relationships to give the business some breathing room. Before you know it, the business will be able to cut you the monthly check you need to live on.
3. Being overconfident. Sometimes entrepreneurs can be using productive debt and believe they’re being wise and cautious. However, in reality, they’re over-extended. Typically, it goes like this: The entrepreneur has a few great years of earnings and decides to expand and increase debt to grow as quickly as possible, but they also change their lifestyle to their new income level. Now comes the downturn in the economy, a change in their industry or the loss of a few large customers. With the resulting major drop in profit, things get pretty rough financially, the situation snowballs out of control and the entrepreneur is at risk of losing their company.
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Getting out of bad or reductive debt
It’s absolutely critical to your long-term success to expunge all reductive or bad debt out of your life as quickly as possible. Implementing a debt snowball is critical. You‘ve probably heard about this type of strategy of spreadsheet or analysis that can fast-track you to getting out of debt quicker than you ever imagined.
The procedure behind the debt snowball is simple.
- Create a simple plan.
- Stick with it.
- Celebrate your success.
First determine how much of your monthly income can be consistently committed to eliminating reductive debt. You need to commit as much as possible. Seriously, the amount of money you’re going to commit to eliminating this debt has to stretch you.
Next, make a list of all your reductive debts in order, beginning with the largest debt at the top of the list and ending with the smallest debt at the bottom. Be sure to include the minimum payment next to each debt on your list.
Now, you’re ready to implement your plan! Simply take the amount of money you committed to your debt plan each month and add that extra cash to the payment of the smallest debt. Continue to make the minimum required payments to all your remaining payments. Soon, your smallest debt will be fully repaid. Now, the snowball increases in size as all the money you were sending to that small debt is now applied to the next larger debt along with its normal regularly required payment. You continue making these increased payments to that debt until it’s eliminated as well. Then you repeat this process over and over until all your debts are gone.
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Staying out of debt
Obviously, the best way to get out of bad debt is to avoid getting into such debt in the first place.
If you want to get out of debt and stay out of debt, it necessitates planning in advance. Here are some core business practices that will help you stay out of debt as you grow and expand:
- Constantly minimizing expenses. It’s OK to be frugal. Make sure to read The Millionaire Next Door: The Surprising Secrets of America’s Wealthy by Thomas J. Stanley Ph.D. and William D. Danko Ph.D. (Taylor Trade Publishing, 2010..
- Hiring employees only when you can afford to do so and expanding your business when the sales come in the door — not in advance, hoping for the growth.
- Avoiding wasteful spending, and always consider the opportunity costs when making financial decisions.
- Not overextending yourself even with productive debt. Be cautious and try to grow on the profits of the business as much as possible.
- Having ample cash reserves to deal with emergencies and potential downturns in your business.
As an entrepreneur, when you find yourself in a situation where your debt is working against you and no longer working for you, then you need to make that debt disappear quickly. In my experience, the entrepreneurs who make it out of these situations will take quick action to cut their expenses and focus all resources on paying down the debt. Staying out of bad debt should not have to be reactionary; it should be part of your operating plan.