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Good debt and bad debt

Good debt and bad debt

Posted on: January 19, 2016
Author: ATB Business & Agriculture

The newest edition of ATB’s Business Beat  reveals Alberta business owners' thoughts about borrowing. We asked Wellington Holbrook, ATB’s Executive Vice-President of Business & Agriculture, to share his perspective on the topic.

What's the difference between good and bad debt for a business?

Quite frankly, debt is generally good for business, because that's how business owners and entrepreneurs can maximize the return on capital. Any business class at any university will tell you that some level of debt is usually a good thing. The only kind of bad debt, in my humble opinion, is the debt that is incurred to cover losses. Basically that's like running up your credit card to buy groceries. At the end of the day, it's not necessarily a sustainable practice and ultimately creates a burden for the business.

There's a perception that well-managed businesses don’t carry any debt. Is this accurate?

It's a tricky question. I would say that the best managed businesses have the right level of debt, and that right level is different for every business.

A lot of very successful, privately owned businesses don't carry a lot of debt and that's really just a reflection of the risk appetite of the business owner. The less debt a business has, the less risky that business is. But the most expensive form of capital a business has is equity. When a business doesn't have any debt, it means that they're using their most expensive form of capital to run the business entirely, as opposed to some rational combination of debt and equity.

To put it another way, if you're in a very risky business—a business that is very volatile, that can change very quickly—probably less debt is better than more debt. But if you're in a business that is very steady and stable and there's much lower risk to the future cash flows of that business, then some degree of debt is probably a really good thing.

Is there any advice you can offer to businesses carrying “bad” debt?

Incurring bad debt, like debt to pay for losses, is something you want to minimize. It isn't necessarily an issue if the business is profitable and well run. The issue is more around incurring it and trying to minimize how much bad debt you take on. Businesses in that situation (and all businesses really) want to make sure that they're maximizing productivity and minimizing expenses wherever they can, and ultimately finding ways to maximize their cash flow.

All businesses will go through ups and downs and when you're in a down period the goal would be to minimize the amount of debt you have to incur to survive that. That's just good advice for all entrepreneurs.

Does an economic downturn provide any opportunities for businesses in terms of debt?

It's funny how things happen. When times are good, we have a chip in our heads that makes us look into the future and think that it's always going to be good. So we become more aggressive and take on more debt. Ironically, that's probably when we should be paying down and reducing debt.

When things are difficult, like the environment we are in right now, it might actually be a good time to take on debt. For a business that is low-leveraged and doesn't have a lot of debt, but has capacity to take it on, this might be great time for some buying opportunities. That could be as simple as buying equipment. You can buy equipment a heck of a lot cheaper than you could a year or two ago in Alberta.

If you're looking to buy another business, now you're going to get a pretty good deal. If you were doing that two years ago, you would've been paying a premium. So quite frankly, you need to be a little bit counter-cyclical to take advantage of opportunities. Anyone that tells you now is a terrible time to be investing may not actually know what they're talking about.

That said, you never know what is going to happen. Again, that is human nature. When things are good we think that they are going to be good forever, but when things are bad, we think that they are going to be bad forever. Truthfully, no one knows how long we are going to have to wait for things to get good again. We are probably approaching the bottom of this economic cycle and although no one knows how long we must wait to get to the upside of it, every day the upside is one day closer.

The current low interest rates could be very enticing to a business owner. What should they do before meeting with their banker about borrowing?

Businesses need to have a really thoughtful plan. The low rates and timing (the toughest part of this economic cycle) could combine to be a very good opportunity. If entrepreneurs are being thoughtful about what they would use that debt for (making investments, buying equipment, changing business, acquiring another business etc.), there can be a lot of great reasons to take on debt. The low interest rates make it that much more appealing. These low rates won't be here forever so it’s not a bad time to be thinking about that. I think most bankers will be supportive of that, if you're running a good business.

Business Beat revealed 70 per cent of businesses are not aware of alternative types of lending. When looking at debt, are there different lending options suited for different situations?

Every business is different and I think understanding that fact is one of the things that banks need to be better at. Here at ATB Financial we have put a big effort into having the best expertise possible for small and mid-sized business owners because we believe every business is unique. Some businesses are very well-suited to alternative lending models, such as Alberta BoostR, and other platforms, and some just won’t need them. But what I will tell you is that if you're dealing with a relationship manager or business banker at ATB Financial, they're going to have your best interests at heart.

Frankly, if you're with a banker that doesn't have your best interests at heart, you should get a new banker. They should be directing you towards these alternative options if traditional solutions aren't going to satisfy you. The truth is, though, that traditional banking solutions are probably going to be the cheapest solutions you can bring to your business the vast majority of the time. It's a great place to start, but it might not be the right place to end.

Another interesting stat from Business Beat is that 17 per cent of business owners would like to see the lending process become more timely and quicker. Is this feasible?

Yes, it’s a totally feasible and reasonable request. For too long we, as financial institutions, have made banking work for us—building processes that work really well for us but aren't as fast or customer-focused as they should be. I know we, like most financial institutions, are really trying to dramatically improve that. We are taking a lot of steps here at ATB Financial to improve but we still have a ways to go.

I think one thing you will see more of is faster response times from financial institutions. If you build a model that is really fast, even if it is more expensive, it might be the speed that makes it more palatable for many entrepreneurs. For example, if the business needs the money now to capitalize on an opportunity, saving 12 bucks but having to wait a couple of weeks for the loan might not be worth it.

We have such strong boom and bust waves in Alberta. What does this mean for businesses in terms of debt? Should they be looking differently at the debt they carry during these polar opposite times?

It comes back to the point that the closer you are to an industry that’s volatile (like the energy industry), the more thoughtful you have to be about the debt that you take on and the timing of that debt. A lot of businesses that have been through this before, especially in the oil and gas industry, probably went into this with very healthy balance sheets, low levels of debt, and a strong capital base to work from.

Businesses that leveraged themselves up heavily are going to be a lot more susceptible to blips and probably are struggling in a much more dramatic way. Some industries are a lot less volatile, like the health care sector. They tend to be a lot more stable and can afford to be bit more leveraged and not be concerned as much about what the boom and bust will do to them, as the impact won't be as dramatic.

It essentially comes down to this: know your business extremely well, know the kinds of risks that you're likely to face as a business owner or entrepreneur, build a plan that creates the right degree of flexibility for you, and capitalize on the opportunities that you can.

I will finish with this: zero debt isn't necessarily the right amount of debt. It could be for your specific business, but debt is still a really important instrument to ultimately optimize your returns. When businesses don't have any debt, it is—more often than not—a missed opportunity to grow, make strategic investments, and ultimately build a more profitable business for the future. When businesses grow, it benefits everybody, the whole economy. It benefits Alberta, it benefits the whole country. So debt isn't a bad thing, it's just knowing your business well enough to make the right decisions.