Cost of Debt Formula

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Small business owners and entrepreneurs often rely on small business financing at some point during the life of their business. A small business loan can be used to cover startup expenses, like marketing, new business equipment, and commercial real estate. Other types of debt, like merchant cash advances (MCA) or a business line of credit, are common types of financing agreements for established businesses that need to cover ordinary operating expenses, fund an expansion, or make a large purchase. While small business loans are an important tool for successful entrepreneurs, all debt comes at a cost. Continue reading to learn more about calculating and analyzing the cost of debt for your business.

Why small business owners need to know the cost of debt

Debt, in financial terms, refers to any amount of money owed to another entity or individual. While balance sheets list debt as a liability, they don’t reveal the expenses tied to it, such as interest costs. These interest payments, which are an inherent component of debt, have a profound impact on your business’s day-to-day financial operations. They represent a recurring outflow that directly influences your company’s monthly expenses. As these costs accumulate over time, they can significantly affect your cash flow and, by extension, your overall profitability.

Understanding the cost of debt provides insight into the total interest and financing costs on outstanding loans. This is critical for managing your business’s financial health, improving your creditworthiness, and ultimately making more informed financial decisions.

How to calculate cost of debt

Calculating metrics like the debt-to-income ratio and cost of debt allows you to measure the financial health of your business. To calculate the cost of debt, you can use a cost of debt calculator provided free by most financial institutions. However, doing the calculation manually is simple and requires only two pieces of information: total interest and total debt.

  • Cost of debt = total interest/total debt

For businesses that have more than one type of loan or business financing, using the cost of debt formula will give you the weighted average interest rate. Examining a weighted average allows you to understand the total cost of all your loans.

For example, if a new dental office takes out a term loan for $150,000 with and annual interest rate of 6.5% to cover the purchase of a new X-ray machine and secure a business line of credit for $50,000 at 8.75%, they can use the cost of debt calculator to understand how much the loans will cost the business.

  1. Total interest = ($150,000 x 6.5%) + ($50,000 x 8.75%) = $9,750 + $4,375 = $14,125
  2. Cost of debt = $14,125/($150,000+$50,000) = 0.0706 = 7.1%

How the cost of debt is impacted by tax rates

The calculations above do not take into account the tax deductions for interest payments. Calculating the cost of debt without including tax rates is sometimes called the pre-tax cost of debt. Considering the tax implications of interest payments will provide a lower, but more accurate, cost of debt. The after-tax cost of debt deducts any reduction in income tax liability from the total cost of debt.

To calculate the after-tax cost of debt, you need to know your effective tax rate, which is found by dividing the total tax by the total income. Both numbers can be found on the previous years’ income tax returns. If you’re curious about your effective tax rate, you can work with your tax preparer or Certified Public Accountant (CPA) to get an estimated rate.

  • After-tax cost of debt = cost of debt x (1 – effective tax rate)

When to use the cost of debt calculator

The cost of debt calculator can be used to understand the weighted average cost of several different types of debt including:

  • Term loans – Business term loans are traditional bank loans where the borrower receives a lump sum of money upfront and repays the loan with monthly payments of principal and interest.
  • SBA loans – Business financing backed by the S. Small Business Administration, SBA loans include several loan programs to provide lower interest loans to business owners.
  • Revolving credit – Financing, like business credit cards and lines of credit, can also be included in cost of debt calculations.

The cost of debt can be calculated periodically (typically monthly or quarterly), as a way to measure financial health. And you can also include it in financial reports distributed to investors, partners, and key employees. The cost of debt should also be calculated when making decisions about restructuring or refinancing debt and taking out new loans. If a business’s cost of debt is too high, consider refinancing one or multiple loans at a lower interest rate. Securing the lower interest rate will decrease the business’s expenses and increase cash flow, like Dr. Eduardo Pignanelli, who was able to consolidate over $4 million of debt at only 4% interest with Biz2Credit.

Bottom Line

The cost of debt calculation is only one of many tools that can be used to measure the financial health of a business. But because it measures the total amount of interest a business will pay for financing, it is a helpful metric in understanding how much a loan actually costs.

Reach out to an expert at Biz2Credit today to learn more about your current cost of debt and alternative business funding options.

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