Thanks to the earnings of our company, we may have the desire to buy something that makes us feel good. Maybe a new car or a house, because our family is growing, or that fancy mobile phone that takes high quality pictures and go on holidays to the most remote location on Earth.

Sometimes, when I talk to business owners, they explain to me they have acquired a new high speed computer that can process data very fast, or that they have invested a lot of funds in a new advertising campaign. When it comes to personal finances, I often hear people explain how cool their new car or the latest mobile phone, or where they’ll go on vacation.

Despite the fact that everyone is responsible for their own finances, it is vital to learn how to use responsibly our available funds. In the end, they are limited, even though when profits have been high over the past years.

Of course I’m not saying that buying yourself a present is something to be avoid. A whim from time to time is good for our mental health and make us feel happier. If we are very strict with ourselves, we won’t be able to make better judgements when making business decisions. Moderation is the key. However, we should analyse carefully how we make use of our financial resources.

One of the big mistakes in business is failing in distinguishing between good expenses, which increases the capacity of your business to generate more profits -or maintain it-, and bad expenses, which on the other hand, cause the opposite effect.

Examples of good expenses:

• Upgrading a machine to produce more units of our most profitable products
• Advertising campaign on a social network that is visited often by potential customers
• Course to develop customer service skills or other business skills
• Hiring a professional to design your website
• Repairing or replacing a machine

Examples of bad expenses:

• New phone with additional features that we don’t need. Why buy a phone with a great camera if we don’t intend to use it?
• Advertising on a social network that is rarely visited by potential customers.
• Company car that isn’t used for business purposes
• A yacht

As you may have noticed, the definition of what is a good or bad expense can be quite subjective, since it depends mainly on the type of business and its goals. However, the main criterion should be that good expenses contribute to the make our business more profitable, while bad expenses cause the opposite effect.

There is more. In business, facing from time to time cash shortages is a common, but not a pleasant experience, especially if for that reason you must delay payments to your employees, key suppliers or the tax bills, among other important creditors. Failing when determining what expenses actually make our business grow, can deteriorate our cash position even more, since bad expenses don’t generate additional revenue. It’s vital to analyse carefully how money is spent by classifying our expenses and how much. In any case, if they exceed our available cash, extra funds may be needed.

To obtain those funds, a good option is to call your bank -or another type of lender-. After running some checks to assess the level of risk, such as your credit score, your a loan is granted. Now you have the money to continue with your operations or expand them, at least for some time. However, depending on the nature of the expenses that cause the cash deficit, debt can similarly be classified as good or bad,

In general, when it comes to debt, we need to avoid to rely heavily on external liabilities, since the interest we have to pay may compromise our cash unnecessarily -especially due to the compound interest– or make more difficult to obtain good payment terms when negotiating with suppliers. As mentioned, it’s not actually a bad idea to borrow some money, but constantly financing your business by external funds can put pressure in your cash flows in the long term and increase the risk of failure of your company, especially when it comes to bad expenses, that can’t generate extra earnings to pay for the loan.

In finance, this is call gearing, which takes into consideration how much of your business is financed by external debt and how much by the owners (or shareholders) or the profits that the business generated. It’s important to have this indicator under control to avoid unpleasant situations, especially when the compound interest may inflate even more your liabilities.

I hope you liked my article. If you have more questions or you need some advice for your business, feel free to drop me a message.