Cost of Debt Formula: What It Is, Why It Matters, and How to Calculate It
Companies exist to earn money, yet a shocking percentage of them rely on borrowed money to keep items on shelves, pay their employees, and pursue new opportunities.
In recent years, plenty of companies have gone deeper into debt because they want to take advantage of low interest rates to buy back stock shares. Share buybacks have become so popular that the S&P 500 only has 10 debt-free companies.
Whether you're a huge, public company trying to retain control of its shares or a small business just trying to make ends meet, you probably carry some amount of debt. That's one reason that you need to know about the cost of debt formula, what it means, and how you can use it.
Calculating a company's cost of debt can become very complex very quickly. So let's start with the basics and work toward more complicated examples. Once you understand the concept better, you can use it to your advantage.
Getting the Information You Need for the Cost of Debt Formula
The term "cost of debt" sounds pretty straightforward. In a simplified world, it would describe the amount of money that you pay to carry debt. In other words, it would equal your interest payments on the debt you need to operate your company.
In the real world, you need a little more information than that. In addition to your average interest rate, you need to know your marginal tax rate.
Once you have these two pieces of information, you can get your cost of debt with the formula:
Effective interest rate * (1 - marginal tax rate)
Keep in mind that this cost of debt formula still takes a very simplified look at your cost of debt. In this scenario, you assume that you have one effective interest rate. In truth, your interest rates probably shift throughout the fiscal year.
At the moment, though, you don't want to get bogged down with too many details. You have to learn to walk before you can run.
Calculating Your Cost of Debt With Tax Included
If the above cost of debt formula left you scratching your head, you will probably understand it better once you add some concrete numbers.
In this example, let's assume that your company paid $2 million in interest on a $50 million loan last year. When you divide your annual interest ($2 million) by your total debt obligation ($50 million) and multiply the result by 100, you get:
$2 million/$50 million * 100 = 4%
Now, you know that you have a 4% effective interest rate.
To find your cost of debt, multiply the effective interest rate by one minus your marginal tax rate. According to the Tax Foundation, corporations can expect to pay slightly under 26% in federal and state taxes.
Let's assume that your business pays the average 26%. Using that, you can calculate your cost of debt as
4% * (1 - 0.26) = 2.96%
You can calculate your business's after-tax cost of debt by plugging your numbers into the equation. It won't give you a perfect answer, but it will give you a good estimate.
Getting More Specific With Your Cost of Debt
Estimates help in a lot of situations. When you need to know your specific cost of debt, though, you have to get deeper into the numbers and consider all of the factors.
For instance, your loan amount probably changes throughout the year because you repay some of the money. At the beginning of the year, you paid interest on $50 million. During the last quarter, though, you may have paid interest on $45 million or $40 million, depending on your loan's term agreement.
You can see how this is going to get complicated in a hurry. As the balance falls, your cost of debt also falls slightly.
The good news is that your cost of debt will look smaller when you take a closer look at it. The bad news is that you probably can't do these calculations in your head. Unless you're really good at math, you probably can't do them on paper, even with help from a calculator.
That's where an amortization table becomes your best friend. If you're only on speaking terms, you might call it an amortization schedule. Regardless of the name, it does the same job. It gives you a detailed calculation of how much you have paid and how much you owe on a loan.
Before you freak out, know that you can find plenty of amortization tables online. Google has a good one that comes with an instructional video. Save yourself a lot of time by watching the three-minute video. If you try to customize the table on your own, it will take you… well, it will take an amount of time that only an amortization table can calculate.
Multiple Forms of Debt
There's one more caveat that you need to consider: your business may have multiple forms of debt. You may have used a business loan from a bank to help you start your business. A couple of years later, you may have used bonds to raise the capital needed to develop a new product. Later on, you might have used an equipment loan for the machinery you needed to manufacture the product.
Each form of debt could have a different principal and interest rate. Before you can calculate your cost of debt, you need to find the average. The calculation to get your average interest rate may look more like:
($2 million/$50 million + $150,000/$3.75 million + $1 million/$12.5 million)/3 * 100 = 5.33%
The point is that the more debts you have, the more factors you need to consider when determining your average interest rate.
If you don't take them into consideration, then you won't get an accurate result. Make sure you go through your expenses carefully to find all sources of debt, including credit card debt.
Unfortunately, any credit card debt will push your percentage up since most companies charge extremely high interest rates. Instead of the 4% or 8% that a bank will charge, your credit card might have an interest rate well over 15%. The credit card won't hurt you too much as long as you keep the balance low. At 15%, though, your credit card balance has three times the weight of a loan with a 5% rate. So, $5,000 on your credit card can cost as much as a $15,000 loan that charges 5%.
When you're talking about high-interest debt, the numbers can get scary very fast.
Figuring Out Your Tax Rate
Terrific, now you know how to get a detailed view of how much money you spend on your debt. You also have an average tax rate that you can use.
Unfortunately, you probably don't pay the average tax rate.
If you want to know your true cost of debt, then you will need to know how to calculate your tax rate. Otherwise, you're just making a (poorly) educated guess.
In 2017, President Trump signed a bill into law that slashed the corporate tax rate from 35% to a flat 21%.
The phrase "flat tax" makes it sound like you don't have to do any calculations to discover your tax rate, right? If all corporations pay a flat tax, then you know that you paid 21%. Easy!
Wait, not so easy. Depending on how you used your money, you could have paid 0% in taxes while earning significant profits. For an extreme example, look to Amazon, everyone's favorite online-store-slash-music-streaming-service-slash-movie-studio-slash-grocery-store.
In 2018, Amazon earned an incredible $11.2 billion. After filling out its tax forms, though, the company's accountants discovered that the government owed Amazon about $129 million. Amazon, in other words, had a tax rate of negative 1%.
Not even President Trump was happy about the situation. But, hey, he signed the law into effect.
How, exactly, did Amazon avoid paying taxes? If you're a pessimist, you would say, "Through the dirty, rotten power of loopholes." If you're an optimist, you would say something like, "Because they used their stock and money wisely to take advantage of benefits built into the new tax law."
But, let's get realistic. You're not Jeff Bezos, and you probably can't afford to hire his accountants. If you are Jeff Bezos, congratulations on becoming the world's richest person! But don't you already know enough about cost of debt formulas? Why are you reading this article instead of planning your next venture?
Your tax burden essentially comes down to how much you paid the government divided by how much money your company made. Once you know your profit and your tax burden, you just divide the numbers to get a percentage. It's really that easy. It's filling out the forms that takes time and sweat.
Why Would You Need to Know Your Cost of Debt?
Now, you have a good idea of how to calculate your cost of debt. But why would you want to? What's the advantage of spending time customizing an amortization table and calculating your precise tax liability?
Any experienced, successful entrepreneur will tell you at least three reasons.
You Save Money by Avoiding Excess Interest
If you haven't calculated your cost of debt, then you don't know how much money your business spends on interest. You might have a vague clue, but you don't have an exact answer.
Many business owners only know how much money they pay their lenders each month. That amount, however, includes money for the loan principal and interest. You don't really know how much you spend on interest, which means you don't know how much your debt costs.
When you take time to calculate your cost of debt, you gain information that can help you make better decisions for your business. You may discover that your debt costs so much that it prevents your company from growing. Once you have that information, you can work toward correcting the situation.
Perhaps even more importantly, learning your cost of debt can motivate you to repay your loans quickly. If you find that you're spending more than you thought, then you will know that you need to prioritize debt reduction.
Few things will set your priorities like seeing how much money you waste on interest payments.
You Create More Room for Business Development and Expansion
Don't take this lightly. Businesses that don't calculate their costs of debt miss important information that prevents them from moving forward. They can't make informed budgets, plan for the future, or know when they will reach financial goals.
Can you afford to hire a new employee, update your storefront, or revamp your website? You can't answer those questions until you know your cost of debt.
If you have plans for your business, then knowing the cost of your debt can help you set priorities that will move you in the right direction. Maybe you'll discover that you have more free funds than you thought. If so, then you might want to take this opportunity to open a new store.
Then again, perhaps you are spending much more money on debt than you thought. If that's the case, then you need to take action to lower your cost of debt. Without taking those steps, your business won't have the funds it needs to grow.
It's a harsh truth, but businesses that don't grow die. Spending too much on debt could kill your dreams of independence and business success.
You Make Your Business More Attractive to Investors and Partners
Do you want to attract investors or partners to your business? Those people will want to know your cost of debt. No experienced investor would spend money on a business without that information. Your cost of debt plays a crucial role in whether your business will earn profits.
Only an amateur would enter an agreement without knowing all of the numbers. That includes the cost of debt.
When it comes to new partners, a lot of people will shy away from your business when they see that you spend too much money on interest. Smart people want to invest in responsible businesses that set and meet goals. If you can't even show someone your cost of debt, that person will not partner with you. Doing so would mean taking on an unknown amount of debt that could cripple the person's future finances!
Ways to Improve Your Cost of Debt
Since lowering your cost of debt can lead to better business opportunities, it makes sense for you to do what you can to improve your score.
All of these options will take some effort. Don't expect to see results overnight. With the right planning and endurance, though, you can improve your cost of debt to save money and open doors to growth opportunities.
Lower Your Interest Rates to Improve Your Cost of Debt
The lower your interest rates are, the less money you have to pay your lenders.
Even a couple of percentage points can help you save a lot of money, especially as your business grows and needs access to more capital. For example, if you borrow $1 million with an 8% annual interest rate, you will spend about $216,580 in interest over a five-year term. If you can convince your lender to lower your interest rate to 6%, then you spend about $160,000 in interest payments. Just two percentage points will save you more than $56,500.
Many borrowers find that they can qualify for lower interest rates when they:
Convince other guarantors to add their names to the loan.
Improve their credit scores by paying off debt and fixing errors on credit reports.
Use personal or business assets as collateral.
Assuming that you have a good relationship with your lender, the bank or investor may not mind lowering your interest rate. Your lender will find a lower interest rate more acceptable when you always make payments on time. Even one late payment can ruin your negotiation.
Repay Your Loans as Quickly as Possible
Given how low interest rates have fallen, it doesn't make a lot of sense for many companies to repay their loans faster than necessary. Hypothetically, though, you could repay the loan early to lower your cost of debt. The less you owe, the lower your interest payments become.
While early repayment may not make much sense now, the economy could change without much notice. If the Federal Reserve decides to increase rates, then repaying your loan as quickly as possible could help you save a considerable amount of money.
You can see the benefits of early repayment by comparing the interest payments of loans with short and long terms. A $1 million loan with a 5-year term and an 8% interest rate will cost you about $160,000 in interest. If you repay the loan within 3 years, though, the interest payments fall to about $128,000.
By dedicating more money to repaying the loan early, you could save more than $30,000.
Refinance Your Business Loan
A few years ago, your business might not have qualified for a low interest rate. Perhaps you accepted a high interest rate with hopes that you could grow your business and make more money. If your plan worked, then refinancing your loan could help you save money.
When you refinance a loan, you borrow money from someone else to repay the original debt. In many cases, you can also refinance several debts into one loan. Ideally, you can get a lower interest rate and a better term that suits your business's current financial needs.
Refinancing gives you similar benefits as lowering your interest rate. Refinancing can also simplify your repayments. Instead of paying several lenders per month, you make one payment to your new lender.
Refinancing can also give you an opportunity to extend your loan's term. Extending the term won't lower your cost of debt (unless you get a lower interest rate, too). It can, however, lower your monthly payments. If you need some extra wiggle room in your finances, try to add a year or so to your loan when you refinance. Doing so can have short-term and long-term benefits as long as you stay focused on repaying your debts.
Increase Your Business's Revenue
Your cost of debt is all about proportionality. It isn't just about how much money you spend on interest. You also need to think about how much revenue your company can generate with the money you borrow.
You have a couple of options, and they both come with some risk. What business move doesn't?
When you borrow money, you can offset the interest payments by increasing your prices. If you sell enough goods or services, a slight price increase could increase your revenue by thousands or millions of dollars. When that happens, you can afford to take on more debt for a while.
You can also use the money you borrow to expand your business to reach more customers, develop new products, or otherwise increase sales. For example, borrowing money could make it possible for you to open a new location that attracts thousands of customers. Without the new location, you wouldn't have access to revenue from those customers. Or, you could spend the money on a new product that performs better than the goods you currently sell.
Keep in mind that this strategy will only lower your cost of debt when you use the additional revenue to repay the loans quickly. Otherwise, you could actually increase your cost of debt. You don't want to fall into that trap.
The Lowdown on Cost of Debt
Nearly every business carries debt. When you talk to investors and entrepreneurs, they expect you to discuss how much money your business owes. That's part of the game in today's fast-paced market.
Maintaining a reasonable cost of debt, however, plays an important role in building a successful business that puts as much money as possible toward growth. When your debt costs too much, your business can't grow. Instead, you exist to help your lender grow. That's terrific for the lender, but it's a bad situation for a business owner.
The first step toward managing your debt is knowing how much it costs. Now that you have the tools to understand your cost of debt and make positive changes, you can start moving your business in the right direction by making informed decisions.