Cost of Debt Explained: Formula, How It’s Calculated & Impacting Factors

There are two ways most businesses seek new financing — through equity financing or debt equity. With equity financing, an investor will provide capital in exchange for ownership of the company (a percentage of the company’s equity). One may define the cost of debt in two different ways; as a pre-tax cost of debt, which is the company’s debt cost before taxes are considered, or as an after-tax cost of debt. Debt costs before and after taxes differ primarily because interest expenses are tax-deductible.

• Business owners can deduct any paid interest on taxes at the end of the year as a business expense.
• Since interest payments are typically tax-deductible, a higher tax rate increases the value of this deduction, lowering the effective cost of debt.
• Given these factors, businesses strive to optimize their weighted average cost of capital (WACC) across debt and equity.
• Debt financing involves fixed repayment obligations, which can create financial strain if a company’s cash flow declines.
• Finally, divide total interest expense by total debt to get the cost of debt or effective interest rate.

Cost of Debt Formula: What It Means and How To Calculate It

To find your total interest, multiply each loan by its interest rate, then add those numbers together. Don’t waste hours of work finding and applying for loans you have no chance of getting — get matched based on your business & credit profile today. Know what business financing you can qualify for before you apply — instantly compare your best financial options based on your unique business data. If you’re just focusing on your loan’s monthly payment and not diving in deeper to analyze the true cost you’re paying, you might be spending more than necessary on your debt. Cost of debt can refer to either before-tax or after-tax cost of debt.

How to calculate the cost of debt

The cost of debt offers several strategic benefits but also carries some limitations that businesses need to be mindful of. By comparing both, companies and individuals can better understand the total cost of borrowing and its financial implications. Management strategies that can reduce your interest burden and improve cash flow.

Fortunately, the information you need to calculate the cost of debt can be found in the company’s financial statements. The cost of debt metric is also used to calculate the Weighted Average Cost of Capital (WACC), which is often used as the discount rate in discounted cash flow analysis. This section will explore the impact of credit ratings and interest rates, market conditions, and debt term and structure on the cost of debt. Capital structure is the mix of debt and equity that a firm uses to finance its operations and fund its growth. The effective interest paid by a company against its loans or debts is called the Cost of Debt.

Debt as a Relatively Cheaper Form of Finance

In this guide, we’ll explore how to calculate the cost of debt, why it matters to your business, and how working with a funding partner like Swoop can optimize the process. The effective pre-tax interest rate the business pays to service all its debts is 5.5%. These strategies are essential for businesses aiming to lower their borrowing costs, improve profitability, and maintain financial flexibility.

• The best business loans are those that offer low rates, but if your personal or business credit scores aren’t high, you may not qualify for those lower interest costs.
• Conversely, a higher cost of debt may cause a company to prefer equity financing, leading to a lower Debt to Equity Ratio.
• In addition to that, the cost of debt helps you calculate your company’s Weighted Average Cost of Capital (WACC).
• Refinancing high-interest debts presents an opportunity to reduce interest expenses.
• Debt comes with fixed interest rates and repayment schedules, making it easier for companies to plan their financial future.

Maintain a Balanced Debt-to-Equity Ratio

This includes loans, bonds, credit lines, or any other form of debt financing. The cost of debt refers to the overall cost that a company pays on borrowed money. Essentially, the interest rate demanded by creditors is the cost of the debt. When the creditors give a loan, they estimate the risks and the borrower’s chances of repayment of the debt. The cost of debt and the cost of equity are both critical in assessing a company’s capital structure.

Debt financing requires consistent cash flow to meet interest payments. This can stifle growth and innovation, particularly for smaller companies or startups with limited cash reserves. A high cost of debt indicates that a company has to pay substantial interest expenses on its borrowings. This can impact profitability and financial stability, potentially limiting growth opportunities. The cost of debt formula cost of debt significantly influences a company’s risk profile.

Businesses that don’t pay attention to cost of debt often find themselves mired in loan payments they can’t afford. Know what the true cost of borrowing money is before you take out a loan and compare products and rates to get the best deal possible. As a business owner, you can look into your weighted average cost of capital (WACC) using your financial statements to make sure it’s spread out across different sources of capital. These shareholders also receive returns on their shares, meaning they get something back for investing in the company.

What Is Unearned Revenue, And Why Is it Good for Your Business?

For example, a company with a credit rating of AAA might secure a loan at a 3% interest rate, while a company with a BB rating could face rates of 7% or higher. Maintaining a strong credit history is essential for reducing long-term financing costs. To better understand how to calculate the cost of debt, let’s walk through a detailed example. This will illustrate how each part of the formula works in practice and how to interpret the result. When obtaining external financing, the issuance of debt is usually considered to be a cheaper source of financing than the issuance of equity.

Empower your finances with purpose-based cards

When you understand the cost of debt, you can make smart business decisions and ensure your business remains profitable. Keep in mind that personal credit quality doesn’t matter as much with business loans. Instead, lenders look at your overall business health when considering a business loan.