Secrets of Small Business Cost of Capital
May 14, 2019 | Last Updated on: April 3, 2023
May 14, 2019 | Last Updated on: April 3, 2023
In some ways, the concept of small business cost of capital is a simple one. Cost of capital 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 the cost of capital. The cost of capital is the price tag on loaned money.
But it’s not all so cut and dried. The secret of the cost of capital is that it isn’t quite as simple as it seems. Cost of capital is an incredibly important and useful metric you can use to strategically acquire new funding in a way that maximizes your profits. But it’s also a helpful tool to use when you’re looking at many of the opportunities that will come your way during your time in business.
You’ll commonly hear it stated that expected revenues need to exceed the cost of capital when it comes to a new loan. If you’re thinking about taking a small business loan to help finance your business needs such as purchasing new real estate, hiring new employees, moving to a bigger space, or purchasing new equipment to help offer new products, your lender will compare the cost of capital they’re offering against your projected revenue growth.
So if your new hires are expected to bring in new business, but the bank loan you took out to hire those new employees costs more than what they make you, lenders will see your business as a poor investment. But how can you make that calculation?
Traditionally, the cost of capital is the price a company pays to acquire funding, including interest and any fees. So when you’re first examining the cost of any capital, it’s smart to calculate your business loan interest.
For example, if your company borrows $150,000 at a 5% interest rate 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 your 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 simple cost of capital.
However, also consider opportunity cost in terms of cost of capital. If there’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 in cost of capital, since the difference is money you’re not earning.
Imagine Investment A is projected to return $15,000 above the initial investment. That number means you’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 your cost of capital.
By including that opportunity cost, your new cost of capital for Investment A is $16,842.84. Suddenly you’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 a lender will. If you’re considering seeking out a new loan, do the calculations on your own first. How much will this new business financing affect your sales and revenue?
If you’re finding the math doesn’t look good, remember: cost of capital won’t always stay the same. What can you do to lower your business loan interest rate? Can you improve your business’s credit score? Are you seeking out a type of loan that may not be the best loan for your intended purpose?
If you’re considering a term loan to purchase a new piece of equipment, you might find that applying for an equipment loan will lead to lower interest rates due to the fact that the equipment can be used as collateral. Those lower interest rates could lower your cost of capital and turn that loan into a winning investment for both you and the lender. It’s vital to choose the right loan.
It’s not just what type of loan that impacts your 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 a small business owner, you have enough data and know-how 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 Year’s resolutions) and May (people trying to get in shape for summer).
With that knowledge in hand, you can truly use an understanding of cost of capital 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 you’d also like to launch an aggressive marketing campaign. You’ve got more product, and you want more people to get eyes on that product. Those two goals together can be expensive, and there’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, you know how 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. Your cost of capital can help you make a good decision.
That’s perhaps the biggest secret of cost of capital. No matter how the numbers work out when you do them, it’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 the cost of capital, but it’s a direct result.
If you’re the owner of the supplement store and you decide the cost of capital 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 you’re unable to move product, you can’t increase revenue.
The cost of capital 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 that’s the worst result you could expect. Instead of taking on debt to increase revenue, you’ve stood still and allowed your revenue to hold steady, or worse start flowing to your competitors.
Cost of capital is a fact of life when it comes to small businesses. You’ll always have to pay a price of some sort for the money you borrow. Even startups that raise venture capital talk about the cost of equity! But understanding how lenders look at your cost of capital 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 your own business. And if your calculations and projections prevent you from making the choices that lead to more revenue, consider all the money you’re losing out on. That’s the real secret to the cost of capital: sometimes, it doesn’t tell the whole story.