Secrets of Small Business Cost of Capital
May 14, 2019
May 14, 2019
In some ways, the concept ofÂ small businessÂ cost of capitalÂ is a simple one.Â Cost of capitalÂ is at its core the price your company pays to acquire funding. At its most basic, if you take out a large loan and repay it in full, the total amount of interest you pay is theÂ cost of capital. TheÂ cost of capitalÂ is the price tag on loaned money.
But itâ€™s not all so cut and dried. The secret of theÂ cost of capitalÂ is that it isnâ€™t quite as simple as it seems.Â Cost of capitalÂ is an incredibly important and usefulÂ metricÂ you can use to strategically acquire new funding in a way that maximizes your profits. But itâ€™s also a helpful tool to use when youâ€™re looking at many of the opportunities that will come your way during your time in business.
Youâ€™ll commonly hear it stated that expected revenues need to exceed theÂ cost of capitalÂ when it comes to a new loan. If youâ€™re thinking about taking aÂ small businessÂ loanÂ to help finance yourÂ business needsÂ such as purchasing newÂ real estate, hiring new employees, moving to a bigger space, or purchasingÂ new equipmentÂ to help offerÂ new products, yourÂ lenderÂ will compare theÂ cost of capitalÂ theyâ€™re offering against your projected revenue growth.
So if your new hires are expected to bring inÂ new business, but theÂ bankÂ loanÂ you took out to hire those new employees costs more than what they make you,Â lendersÂ will see your business as a poor investment. But how can you make that calculation?
Traditionally, theÂ cost of capitalÂ is the price a company pays to acquire funding, including interest and any fees. So when youâ€™re first examining the cost of any capital, itâ€™s smart toÂ calculate your business loan interest.
For example, if your company borrows $150,000 at a 5%Â interest rateÂ and a 36-month term, you can expect to pay $11,842.84 in interest. That interest, in addition to any fees you pay in the process, is yourÂ cost of capital. If you project that $150,000 loan to create more than $11,842.84 in additional revenue, it seems to be a wise investment in the lens of simpleÂ cost of capital.
However, also consider opportunity cost in terms ofÂ cost of capital. If thereâ€™s a different possible investment with your $150,000, you should calculate the projected return on that investment. If the projected return on the alternate investment is greater than the projected return on your original investment, the difference should be included inÂ cost of capital, since the difference is money youâ€™re not earning.
Imagine Investment A is projected to return $15,000 above the initial investment. That number means youâ€™re making a profit on the $11,842.84.
But Investment B is projected to return $20,000 from improvements made with the same $150,000 loan. Choosing Investment A over Investment B means leaving $5,000 on the table, which you should include in yourÂ cost of capital.
By including that opportunity cost, your newÂ cost of capitalÂ for Investment A is $16,842.84. Suddenly youâ€™re not turning a profit anymore.
You can use your knowledge to your own advantage. Always be looking at your company with the same sort of prying eyes aÂ lenderÂ will. If youâ€™re considering seeking out a new loan, do the calculations on your own first. How much will thisÂ newÂ businessÂ financingÂ affect your sales and revenue?
If youâ€™re finding the math doesnâ€™t look good, remember:Â cost of capitalÂ wonâ€™t always stay the same. What can you do toÂ lower your business loanÂ interest rate? Can you improve your businessâ€™sÂ credit score? Are you seeking out a type of loan that may not be the best loan for your intended purpose?
If youâ€™re considering a term loan to purchase a new piece of equipment, you might find that applying for an equipment loan will lead to lowerÂ interest ratesÂ due to the fact that the equipment can be used as collateral. Those lowerÂ interest ratesÂ could lower yourÂ cost of capitalÂ and turn that loan into a winning investment for both you and theÂ lender. Itâ€™s vital toÂ choose the right loan.
Itâ€™s not just what type of loan that impacts yourÂ cost of capital. Knowing the best time to apply for those specific loans can also lead to lowering how much you have to pay out as well.
Many businesses have a slow season and a peak season. As aÂ small businessÂ owner, you have enough data andÂ know-howÂ to understand when those times come. If, for example, you run a business selling workout nutritional supplements, you know your peak times will likely be in January (for those with New Yearâ€™s resolutions) and May (people trying to get in shape for summer).
With that knowledge in hand, you can truly use an understanding ofÂ cost of capitalÂ to your advantage. If your supplier is able to offer a discounted rate at the end of the year, it may be prudent to acquire funding to stock up on your most popular inventory.
Or perhaps youâ€™d also like to launch an aggressive marketing campaign. Youâ€™ve got more product, and you want more people to get eyes on that product. Those two goals together can be expensive, and thereâ€™s a chance that a basic examination of the cost of that capital would make such investments look unwise for that year.
Because context matters. Even though the return on additional inventory may not happen immediately, youÂ know howÂ much your sales are likely to spike in January and May, so you know you need to ensure your inventory is fully stocked. But a marketing campaign at that time could just be throwing money at people who are already ready to buy. YourÂ cost of capitalÂ can help you make a good decision.
Thatâ€™s perhaps the biggest secret ofÂ cost of capital. No matter how the numbers work out when you do them, itâ€™s important to remember that there are innumerable situations where not acquiring a new loan will lead to stagnation or a decrease in sales. That stagnation may not show up in your calculations of theÂ cost of capital, but itâ€™s a direct result.
If youâ€™re the owner of the supplement store and you decide theÂ cost of capitalÂ is just a little too high to get the sort of loan that leads to a full inventory, you may find yourself selling out of product in January. And if youâ€™re unable to move product, you canâ€™t increase revenue.
TheÂ cost of capitalÂ calculation might not change. But what could change is that your potential customers could find an alternative product and move on from your company. And thatâ€™s the worst result you could expect. Instead of taking on debt to increase revenue, youâ€™ve stood still and allowed your revenue to hold steady, or worse start flowing to your competitors.
Cost of capitalÂ is a fact of life when it comes toÂ small businesses. Youâ€™ll always have to pay a price of some sort for the money you borrow. EvenÂ startupsÂ that raiseÂ venture capitalÂ talk about the cost of equity! But understanding howÂ lendersÂ look at yourÂ cost of capitalÂ in comparison to your revenue can help you make the best choices with it comes to borrowing.
Remember that making money is the most important part of operating yourÂ own business. And if your calculations and projections prevent you from making the choices that lead to more revenue, consider all the money youâ€™re losing out on. Thatâ€™s the real secret to theÂ cost of capital: sometimes, it doesnâ€™t tell the whole story.