Cost of Debt Definition | How to Calculate It for Your Business
Any business owner needs multiple tools to calculate their finances so they can get a bird's eye view of their company's financial situation at any time. As your company grows and you take investment cash from lenders, you'll also accrue debt. Even after the initial stages of growth, your company will still need to take on debt to expand, build infrastructure, and more. As you take on debt, those debts' interest rates will start to weigh down on your income streams. Calculating the cost of debt for your business can help you determine whether that debt is becoming too unwieldy to manage and help you plan where your income is going more precisely. Fortunately, calculating the cost of debt for your business isn't too difficult once you break down all the necessary terms. Let's go over how to calculate the cost of debt now.
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.
How to Calculate the Cost of Debt
The good news is that it's easy to leverage this effective tool for your own business. Calculating the cost of debt for your company is fairly straightforward. To do this, you'll need to first find two pieces of information: the marginal tax rate for your company and the effective interest rate that it pays on all of its debts. If you're tackling the cost of debt for your own company, all you have to do is look at your income statement(s) and tally up the total interest you paid on any debts, loans, or bonds. Next, look at your balance sheet(s) and find the total amount of debt your company is carrying across investors or lenders. Once you have both of these numbers, you'll be able to find the effective interest rate. The effective interest rate = company's annual interest/company's total debt obligations x 100 This is not an exact science, however. Many companies have fluctuating amounts of debt, especially as they grow older and become more financially stable. If you want to find the total consistent cost of debt, you can calculate the average of your company's debt load from the four most recent quarterly balance sheets instead. Take the debt from each quarter, add them up, and divide that resulting number by four. Regardless, once you have your effective interest rate, you have one half of the equation to calculate the cost of debt for your company. You next need your company's marginal tax rate, and you'll need to combine both state and federal taxes. For larger corporations, the federal marginal tax rate is around 35% (i.e. this applies to any corporations with income over $18.33 million). Meanwhile, state corporate income tax rates can range from anywhere between 0% to 12%. It all depends on how much your company is taxed. Once you have that number, you can use the following equation to find the cost of debt for your company: Cost of debt after taxes = company's effective interest rate x (1 – company's marginal tax rate) Your company's cost of debt before taxes is simply the number you get by dividing your company's annual interest by its total debt obligations and multiplying by 100.
Example Scenario
That's a lot of numbers! Don't worry; we'll test out these equations in an example scenario. Say that your business has $300,000 in debt in total. $200,000 of the debt comes from a bank with a 6% interest rate. $100,000 of the debt comes from an angel investor with an interest rate of 4%. Thus, the total annual interest of both loans will be $16,000. We get this by multiplying 6% x $200,000 (which gives us $12,000), as well as added 4% x $100,000 (which gives us $4000). Remember, your total amount of debt is $300,000. Now divide $16,000 by $300,000. You get 5.3%: the effective interest rate for this hypothetical company. To get the after-tax cost of debt for your company, simply multiply 5.3% by 1 minus your company's marginal tax rate. The best way for the company to use this information is to then determine whether the amount it’s paying in interest. This way, executives can decide on a debt repayment strategy that works for their needs.
Summary
Calculating the total cost of debt for your company is one of many tools you can use to accurately determine your company's actual income value and help get a better picture of what your money is spent on. It's also a great way to value your company or to determine whether you need to be more aggressive in paying down your debts before they become too heavy for your company to handle. If you need help with funding or other financial solutions, Seek Capital is always just a click away for business loans and other business resources ! Sources https://www.taxpolicycenter.org/briefing-book/how-does-corporate-income-tax-work https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-structure-overview/ https://www.fool.com/knowledge-center/what-is-cost-of-debt.aspx