Individuals who take out loans usually focus on creating capital to grow a business. Sometimes, entrepreneurs take out loans to stabilize a company’s cash flow. All loans come with repayment terms and options, and when individuals pay their bills on time, they build credit.
However, suppose an entrepreneur focuses solely on making the monthly payments and does not delve deeper into the true cost of the debt. In that case, they spend more than necessary on financing. In this article, we will examine the cost of debt formula to ensure that entrepreneurs thoroughly understand what their debt entails.
What Does Cost of Debt Mean?
Businesses use two types of capital: debt equity and equity financing. Investors use equity financing to provide working capital for an equity percentage or company ownership. In this case, the investors are usually angel investors or venture capitalists.
When using debt equity, the company takes out an SBA loan, invoice financing, or another type of financing, such as a merchant cash advance. The company pays the loan over months or years, along with an interest expense. Although the term ‘debt equity’ confuses some people, it essentially refers to a loan.
Building on these definitions, the cost of debt describes the interest expense individuals pay on all the loans the company has taken out. The individual adds up the interest rate for each loan to figure out the business’s cost for its debt.
How is Cost of Debt Calculated?
When individuals know the cost of their debt, they understand precisely what they are paying in exchange for easy access to cash.
To calculate the cost of total debt, add up all of the company’s financing tools, including loans and credit card balances.
Next, calculate the expense of annual interest rates for each financing tool, and add these figures together.
Lastly, divide this total interest figure by the total amount of company debt. The resulting number is the cost of debt.
What is the Cost of Debt Formula?
Calculating the cost of debt can be done in a few different ways, depending if the debt is pre-tax or post-tax. For the pre-tax cost of debt, this formula can be used:
Total interest / total debt = cost of debt
However, often businesses can save money on taxes if their loans have deductible interest expenses. Here, it is necessary to calculate the post-tax cost of the debt. For this calculation, one needs the effective rate of tax.
Before we calculate the post-tax debt cost, here is another helpful phrase: the weighted average cost of debt. This figure is the total interest the business is paying, including all loans.
To calculate the weighted average interest on the loan, multiply the interest rate paid by each loan.
For example, Ted runs a surf shop in Laguna Beach. To start the shop, Ted received an SBA loan of $100,000 with an interest rate of 5%. So, the weighted average is $5000.
Ted used a business credit card to buy boards and other items and spent $5,000. The interest rate is 22.5%, and the average is $1,125.
Ted also takes advantage of a merchant cash advance for surf clothing and wetsuits, which is $3,000 X 30%, equaling $900.
Next, add these three results together: $7,025.
Now, add up the debts: $3,000 + $100,000 + $5,000: $108,000.
Divide the interest ($7,025) by the total ($108,000), and you will have the rate of weighted average interest: 6.5.
The formula for cost of debt that includes tax cost at the assumed corporate tax rate is:
- The effective interest rate X (1 – tax rate)
- The weighted average interest rate is the effective interest rate.
Cost of Debt Examples
There are two ways to calculate the cost of a company’s loans. First, the calculation depends on whether the price is pre-tax or post-tax.
Cost of Debt: Simple
To find out how much the business pays in interest, use this easy formula:
Total interest / Total debt = Cost of Debt
For example, if an individual pays $3,500 in interest for all their loans during the year, and their total debt is $70,000, the simple cost of debt is 5%
$3,500 / $50,000 = 5%
Cost of Debt: Complex
Some entrepreneurs want to know how their debt cost changes after taxes.
The formula is:
Effective interest rate X (1 – tax rate)
If a business has a 9% corporate tax rate and a 6.5% weighted average rate, for example, then the formula would be:
6.5% (or .065) * (1-.09) = .591 or 5.9%
After taxes, the cost of debt would be 5.9%.
What Causes the Cost of Debt to Decrease?
Many people wonder why it is essential to calculate the cost of one’s debt. However, this simple figure reveals whether a business is spending too much on financing. The cost of debt can also show whether taking on specific types of debt makes sense by calculating the cost of the tax on the debt.
For example, Mindy is starting a shoe store, and she hopes to take out a loan that, if accepted, will allow her to write off $3,000 in interest for the year.
The loan makes sense if the cost of Mindy’s debt is less than $3,000. However, if the cost is higher, Mindy should examine other options that could provide a lower cost of interest.
Mindy may still decide to take the loan if she needs the money to grow the business, but everyone should examine other options first.
Lowering the Cost of Debt
Reducing debt costs is possible. Begin by carefully selecting the financing that the business uses. Then, choose business loans that offer low rates. However, if an individual’s business or personal credit scores are not high enough, it might be difficult to qualify for low-interest loans.
Luckily, individuals can build their credit scores by paying bills on time and managing their debt more intelligently. Debt usage or debt utilization refers to an individual’s revolving credit accounts. If too many unpaid balances exist, their credit score is adversely affected.
What is Debt APR?
Debt APR is often confused with the cost of debt, but these concepts are not the same. Annual Percentage Rate (APR) describes how much business credit cards or loans cost the debt holder for an entire year.
On the other hand, the debt cost encapsulates the total interest a borrower pays over the loan’s lifetime.
What is the Cost of Debt?
Hopefully, this article has clarified not only the definition of the phrase “cost of debt” but the way the cost of debt can be used and analyzed.
Corporate capital structures with long-term debts must understand the true cost of their accrued debt. It is also important for entrepreneurs and businesses to understand that credit cards and business loans can maintain cash flow, but there is a price. That price is debt.
Companies that do not pay attention to their true debt costs must make multiple loan payments. As a result, many cannot afford the monthly bills that come with these loans. Therefore, knowing the true cost of borrowing money before signing off on a loan is paramount and allows individuals and businesses to compare rates and be certain they have the best deal.
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