Cost of Debt: Definition, Formula, Calculation & Example
Businesses have two avenues for raising capital. The first is equity financing, and the second is debt equity. With equity financing, an investor loans money to a business in exchange for small company owners. This is typically issued in the form of shares that represent the ownership percentage. Paying a shareholder can cost more than financing business needs through a lender.
Debt equity means that a company pursues more formal financing like:
- Long-term debt like an SBA loan
- Short-term debt like a merchant cash advance
- Invoice financing
- Credit cards and other types of financing
Any borrowed monies get repaid with interest using monthly payments. Typically the longer debt is financed, the more interest the business pays. Business owners benefit from set payoff amounts and tax write-offs for interest.
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KEY TAKEAWAYS
- Cost of debt is a formula used to ensure that business purchases are profitable.
- Any interest you pay on debt is tax-deductible. You can calculate the cost of debt with or without factoring in tax savings.
- Ideally, the cost of debt is lower than the profit you make on any debt-funded purchases for your business.
What is the Cost of Debt?
The cost of debt involves a formula that factors the total expense a business incurs with debt. Some companies calculate the cost of debt using interest only. Other companies factor in potential tax savings into the formula. The difference between the two calculations is that interest expenses are tax-deductible.
How to Calculate the Cost of Debt
At a basic level, the cost of debt formula is total interest divided by total debt. Total interest / total debt = cost of debt. You use this formula for each individual debt you owe. Many businesses choose to calculate the weighted cost of debt. This is the average interest across all of your outstanding debts.
Keep in mind that the cost of debt changes over time. Company-specific debt usage may be higher and lower at different times of the year. Itās best practice to monitor the cost of debt over a long period of time. To see the big picture you also want to complete cash flow analysis and look at the cost of capital, too.
Examples of Cost of Debt
Let’s say that your business has three individual types of debt:
SBA loan: $50,000 * 6% =$3,000
Business credit card: $10,000 * 15.5% = $1,550
Merchant cash advance: $8,000 * 20% = $1,600
Now you add up the total interest: $3,000 + $1,550 + $1,600 = $6,150
Then you add up your total debts: $50,000 + $10,000 + $8,000 = $68,000
Divide your total interest by the total amount of debt to get your average cost of debt: $6,150 / $68,000 = .09.
The weighted average interest rate for your mix of debt is 9%.
Factor Taxes into Cost of Debt Formula
There’s also a formula for calculating any tax savings into the total. If you want to factor in tax savings, you need to know two numbers. First, you need the weighted average interest rate. In the above example, the average rate is 9%. Next, you need to know your corporate tax rate. We will use 8% as an example in the formula below.
Using the Cost of Debt Formula for our example, we get: .09 x (1 – .08) = .083
Hence, for our example, the average weighted interest rate with tax savings factored in is 8.3%.
Cost of Debt and How it Impacts Taxes
Business owners can deduct any paid interest on taxes at the end of the year as a business expense. You don’t have to claim this deduction as a business owner, but every little bit adds up. Deducting interest payments can lower the amount of taxes you owe.
Many business owners work with their accounting team to factor in costs and savings before ever pursuing debt. Some types of debts may not be worth the cost, while others may offer enough benefit to outweigh the costs.
Summary
The U.S. Federal Reserve estimates that 43% of small businesses need external funding to grow and scale. This funding usually comes in the form of debt. When you understand the cost of debt, you can make smart business decisions and ensure your business remains profitable. Keep in mind that personal credit quality doesn’t matter as much with business loans. Instead, lenders look at your overall business health when considering a business loan.
For example, you know that a new piece of equipment will mean that you can produce more of your product with a shorter turnaround time. This new piece of equipment can increase your revenue by 10%, but you need a loan to pay for it. If you calculate the cost of debt at 7%, the loan is worth it. You still have a 3% profit for your business.
If the cost of debt will be more than 10%, the expense may not be worth it. You will pay more in interest than your business makes in the same period of time. Of course, if the equipment will last you ten years and you can pay the loan off in three years, that may be worth it. You just won’t see a return on this investment until you pay off the debt.
FAQs on Cost of Debt
Debt cost is a formula that takes other factors into account when calculating how much a loan costs your business.
Debt has a cost because of the interest rates that lenders charge when you borrow money. A debt holder treats interest as their income for loaning out money to business owners.
Your cost of debt may increase if you choose more expensive lending options.
Cost of debt refers to loans and credit cards. Cost of equity refers to the amount a business pays shareholders.
You can calculate the net cost of debt using this formula: weighted interest rate x (1 – corporate tax rate) = cost of debt.
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