# Cost of Debt Definition | How to Calculate It for Your Business

## What Does "Cost of Debt" Mean?

In a nutshell, the cost of debt of a company is the same thing as the effective interest rate that it pays on its combined debts. Combined debts include loans, bonds, and other forms of debt that a company may collect either from investment opportunities or from regular operations. The regular cost of debt is often called the “before-tax” cost of debt since it's how much the company's debt costs before taxes are considered. Furthermore, the cost of debt after taxes is usually a different number since interest expenses are tax-deductible, resulting in a different total balance in many cases. Combined with the cost of equity (or the cost of the company's value, which can include assets), the cost of debt is one part of a company's total capital structure. In order to find the cost of debt, individuals usually have to find the average interest paid across all of a company's different debts, which can be complex.

## How Does the Cost of Debt Work?

Above, we mentioned the capital structure of a company. This is essentially how a company manages to pay for its operations and continued growth. For example, what funds does the company have from profits and from products and services? What funds does the company have from debt, such as investment bonds or convertible notes? All of these things combined affect what a company can buy and do. The cost of debt can also be thought of as a measurement that can be helpful when you want to understand the overall rate paid by your company when financing for debt or taking out additional business loans . Furthermore, investors are often interested in the cost of debt for a prospective company since it can indicate one risk level or another compared to other, similar companies in the same niche. When a business calculates the total cost of debt, it can determine whether it's paying too much in interest to sustain operations as they currently are. For instance, if the interest rates on its combined debts are so large that the company will run out of funding for its regular services, that means the debts will eventually cause the company to go bankrupt. This can tell the company that it needs to pay off its debt sooner rather than later so that interest does not continue to accrue.

## Why Use the Cost of Debt as an Analysis Tool?

In addition to the above uses, companies also calculate the cost of their debt and the cost of their equity in order to come up with a term called the WACC, or the weighted average cost of capital . This single number essentially breaks down how well a company needs to perform to satisfy lenders and investors or other shareholders. As mentioned above, calculating the cost of debt can also help the company avoid bankruptcy or other financial disasters by identifying how much money is being funneled toward interest rates. That money could always be better spent elsewhere, so companies may be able to strategically pay off certain debts to lower their total cost of debt. Done correctly, this may free up more income for regular operations or for expansions. More importantly, the cost of debt is an important analysis tool for startups and newer companies that may have more debt than they have income. To get off the ground (i.e. to pay for things like infrastructure, new facilities, hiring employees, and other startup costs), most startups and small businesses need to take out lots of debt for at least five years. This involves speaking to investors or otherwise getting financing through debt-based means. Companies can calculate the cost of their debt when determining how much debt they can realistically take on before their interest rate payments outstrip their ability to spend cash on other things. Even for older companies, the cost of debt can be important when planning large-scale expansions or other big cash expenditures.