Whether you need to hire new employees, purchase equipment, open a new location, or develop a new product, you’ll likely need to borrow money to finance your new business ventures.
Pretty much every small business needs financing to succeed. Of course, most of us don’t have enough free cash flow to pay for everything out of pocket. So taking on debt as a small business is perfectly okay.
But it’s important to consider your cost of debt — that is, the total interest you have to pay over the term of a loan. Debt should always be used to help your business grow. If your cost of debt is too high, though, it might not be worth it.
By learning how to use the cost of debt formula, you can get a better understanding of your small business’ financial health and learn how to lower your cost of debt.
What is Cost of Debt?
The cost of a loan depends on more than the amount you borrow. That’s why we calculate the cost of debt—to determine how much your debt really costs.
Cost of debt, not to be confused with the cost of sales, is the total amount of interest your company pays on all of your debt, including loans, business credit cards, and other types of debt.
It is often used by business owners to determine how a new loan can increase business profits. Moreover, it helps companies identify new deductions as interest paid on business debt is tax-deductible.
Why Should I Calculate My Cost of Debt?
Why bother calculating your cost of debt?
As I mentioned, the benefits of learning the cost of debt formula revolve around two things: profits and taxes.
As a small business owner, most of what you do is probably based around increasing your business profits. By using the cost of debt formula, you can determine whether or not taking out a new loan is worth it. If the cost of debt outweighs the expected profits, it’s probably not worth it.
Since the interest paid on business debt is deductible, the cost of debt formula can help you maximize your business’ tax deductions.
Lastly, when you do apply for a new business loan, lenders might want to take a look at your cost of debt before deciding whether or not to approve your application. If you have too much debt, lenders may not want to risk lending to you.
To successfully run a small business, you need to stay on top of your finances. Learning how to calculate your cost of debt and understanding what it means is one of the ways you can take control of your company’s finances.
How Do You Calculate Debt? With the Cost of Debt Formula
Ready to learn how you can calculate your cost of debt?
Don’t worry; it’s easier than you probably think. By learning the cost of debt formula and understanding how to use it, you can quickly and easily find out the cost of your business’ debt.
The cost of debt formula is as follows:
Cost of Debt = Interest Expense ✖️ (1 ➖ Tax Rate)
Now, let’s break down the different parts of the cost of debt formula so we can understand it a little bit better.
First, you’re going to need to find your business’ income tax rate.
You should be able to get this information from your business’ accountant. Don’t forget that you need to account for federal, state, and local taxes.
To find your company’s average income tax rate, divide your total tax liability by your total taxable business income.
The other relevant term in this formula is ‘interest expense,’ which is the total amount of interest you have to pay over the duration of your loan. This should also include any tax-deductible loan fees.
Most lenders will give you an annual percentage rate (APR) quote, which already accounts for interest and fees. To find out the total cost of interest, you can ask your lender or use a business loan calculator.
Once you have these two numbers, you can use the cost of debt formula as intended.
How to Lower My Cost of Debt
You should do a cost of debt analysis every time you consider taking out a new business loan. It’s one of the most effective ways to determine whether or not a loan is worth the cost.
If, after using the formula, you find that your business’ cost of debt is higher than it should be, here are a few ways to lower your cost of debt.
Refinancing your business loan can be a great way to lower your interest rates. If your business credit score has improved since you took out your loan, you might qualify for better rates.
2. Shorter Terms
Assuming your interest rate is the same either way, shorter terms result in less money paid in interest. If you can afford the higher monthly payments, a shorter term can lower your cost of debt.
3. Improve Credit
The best way to ensure you get low-interest rates is to improve your business’ credit score. You can do this by making your loan payments on-time, lowering your credit utilization, and more.
4. Use Collateral
You can also qualify for lower interest rates by opting for a secured loan. If you have valuable personal or business assets, they can be used to secure your business loan and lower your rates.
5. Find the Right Lender
One of the best ways to find great interest rates is to shop around and compare prices. At Camino Financial, we offer small business loans with great rates and terms as part of our effort to live up to our motto, “No Business Left Behind.”
As you can see, lowering your cost of debt is all about reducing the amount of money you pay in interest either through lower interest rates or shorter repayment terms.
The Cost of Debt Formula in the Real World
Understanding how to use the cost of debt formula is much easier with an example. Let’s take a look at how you might use this formula in the real world.
Let’s say you own a home improvement store and need to take out a business loan to purchase more inventory for your store.
Now, say your lender gives you a quote of 12.5% APR on a $125,000 loan, and your business’ average tax rate is 23%.
For simplicity, also assume that your interest is applied to the loan upfront, so your interest expense would be $15,625 according to the following calculation:
Interest Expense = 125,000 x 0.125 = $15,625
With these numbers, we can use the cost of debt formula that we took a look at earlier:
Cost of Debt = 15,625 x (1 – 0.23) = $12,031.25
In this example, your cost of debt for the loan you need to purchase inventory would be $12,031.25.
Now, to determine whether or not the loan is worth it, you can compare this number with the total profit you expect the new inventory to generate.
If, for example, you expect the sale of your new inventory to generate $40,000 in profit, then this loan might be a good investment. If you only expect it to make $10,000, on the other hand, then you should probably look for a loan with a lower interest rate.
Be Smart When Acquiring Debt
Cost of debt is an essential concept that all small business owners should be familiar with. It can help you maximize your profits, identify tax deductions, and help you get a business loan.
Fortunately, the cost of debt formula is relatively simple and easy to use. By taking the time to understand how to use this formula, you can take control of your business’ finances.
If you’re having trouble finding an affordable small business loan, be sure to request a quote for a business loan from Camino Financial today!
We strive to live up to our motto, “No Business Left Behind.” That’s why we offer business loans with competitive rates, favorable terms, and other great resources to help small business owners like you succeed.