If you’re a small business owner, you know that borrowing money is both inevitable and essential. You need working capital to get your business off the ground or grow it to new heights. You might even need it to steady your cash flow.
The loans and debt you take on to get that cash come with interest rates. If you don’t keep track of your cost of debt, those expenses can get out of control. You’ll be blind to the true cost of your financing, and you might take out another loan you can’t afford.
Calculating your cost of debt will give you insight into how much you’re spending on debt financing. It will also help you determine if taking out another business term loan or business line of credit is a smart decision.
What Is Cost of Debt?
Cost of debt is interest expense. In other words, cost of debt is the total cost of the interest you pay on all your loans.
Your annual interest rates determine your company’s debt cost. The lower your interest rates, the lower your company’s cost of debt will be — you want the lowest cost of debt possible.
Lenders examine your business’s finances using financial documents, including a balance sheet. They also use metrics, such as credit rating, to determine an annual interest rate. Loan providers want to ensure that borrowers are able to pay them back. To lower your interest rates, and ultimately your cost of debt, work on improving your credit score.
Fortunately, some interest expenses are tax deductible. This tax break lowers the amount of interest debtholders pay, which lowers their cost of debt. To see if your tax savings will cover your interest expenses, you’ll use a different formula to calculate your cost of debt after taxes.
How to Calculate Cost of Debt
There are two ways to calculate cost of debt: one is pre-tax cost of debt, and the other is after-tax cost of debt.
To calculate cost of debt before taxes, divide the total interest of all your loans by the total debt of all your loans.
To calculate cost of debt after your interest-based tax break, multiply your effective interest rate by your effective tax rate subtracted from one.
What Is the Pre-Tax Cost of Debt Formula?
The pre-tax cost of debt formula is:
Total interest / total debt = cost of debt
To find your total interest, multiply each loan by its interest rate, then add those numbers together.
To calculate your total debt, add up all your loans.
Then, divide total interest by total debt to get your cost of debt.
The cost of debt you just calculated is also your weighted average interest rate. This rate will help us complete our next calculation — after-tax cost of debt. This interest rate is also important if you want to calculate your weighted average cost of capital (WACC).
What Is the After-Tax Cost of Debt Formula?
The after-tax cost of debt formula is:
Effective interest rate x (1 – effective tax rate)
The effective interest rate is the weighted average interest rate we just calculated. You need to know your tax rate to complete this calculation.
First, subtract your effective tax rate from one. Then, multiply that by your effective interest rate, or weighted average interest rate, to get your after-tax cost of debt.
Cost of Debt Examples
Although you can use Excel or Google Sheets for bookkeeping, it’s helpful to know how to be your own cost of debt calculator. Here’s an example of how to manually calculate cost of debt.
Let’s say your small business has taken out three loans:
- Small business loan: $125,000 at a 6% annual interest rate.
- Business credit card: $7,000 at a 23% annual interest rate.
- Line of credit: $4,000 at a 33% annual interest rate.
Pre-tax cost of debt
Our pre-tax cost of debt formula is:
Total interest / total debt = cost of debt
To get our total interest, we’ll multiply each loan by its annual interest rate, then add up the results.
$125,000 x 0.06 = $7,500
$7,000 x 0.23 = $1,610
$4,000 x 0.33 = $1,320
$7,500 + $1,610 + $1,320 = $10,430
So, our total interest is $10,430.
To get our total debt, we’ll add up all our loans.
$125,000 + $7,500 + $4,000 = $136,500
$136,500 is our total debt.
Now, let’s plug in those numbers:
10,430/136,500 = 0.08
8% is our weighted average interest rate, or pre-tax total cost of debt.
After-tax cost of debt
Let’s say our business’s corporate tax rate is 11%.
Our after-tax cost of debt formula is:
Effective interest rate x (1 – effective tax rate)
As we learned from our pre-tax calculation, our effective interest rate is 8%. So, now we have everything we need to complete this calculation.
0.08 x (1 – 0.11)
0.08 x (0.89) = 0.07
Our after-tax total cost of debt is 7%.
Cost of Debt vs. Cost of Equity
The cost of debt is the cost of paying money back to lenders. The cost of equity is the cost of paying shareholders their returns.
Both debt and equity make up your company’s capital structure. Equity capital is generated from investors buying shares. In exchange for investing, shareholders get a percentage of ownership in the company, plus returns. Rate of return is calculated by investors before they invest.
Cost of debt is repaid monthly through interest payments, while cost of equity is repaid through returns, such as dividends.
This content is for educational and informational purposes only, and is not intended as financial, investment or legal advice.
