Cost of Debt: Definition, Examples, and How to Calculate?

While this figure might seem shocking, much of this debt helps people make important financial decisions and it often gets paid off on time. Ideally, publicly traded debt from the company in question will provide the most accurate source of information. This, however, is not always possible if the debt is not publically traded and reviewing benchmarks to similar credit is the next best option.

Tax Implications

You need to factor taxes into the equation to determine the after-tax cost of debt. The simplest way to figure out your total cost of debt is to use the following formula. For small businesses, every dollar counts toward success or failure. Taking on some debt may provide much-needed capital to expand operations, purchase equipment, hire staff, or bridge cash flow gaps. With debt equity, a company will receive financing as a loan to be repaid over time with interest. 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.

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. Debt and equity are two ways that businesses make money, but they are very different. how to find the cost of debt While we now know that the cost of debt is how much a business pays to a lender to borrow money, the cost of equity works differently.

With debt equity, a company takes out financing, which could be small business loans,  merchant cash advances, invoice financing, or any other type of financing. The loan is repaid, along with an interest expense, over months or years. The term debt equity could be confusing, but it’s basically referring to a loan.

Examples: Calculate Cost of Debt in Excel or Google Sheets

Watkins suggests contacting creditors to try negotiating interest rates down, or ask to forgo payments for a while. If you’re expecting a refund, using it to pay off debt, especially high-interest credit cards, could be a good choice, McClary says. Chapter 13 bankruptcy is sometimes seen as more favorable than Chapter 7 due to the built-in repayment plan — lenders can view this as you trying to repay your debts in good faith.

Signs Your Business Needs a Loan

For example, if a company’s only debt is a bond that it issued with a 5% rate, then its pretax cost of debt is 5%. If its effective tax rate is 30%, then the difference between 100% and 30% is 70%, and 70% of the 5% is 3.5%. The rationale behind this calculation is based on the tax savings that the company receives from claiming its interest as a business expense. As with most calculations, the first step is to gather the required data.

Debt consolidation is generally free from drawbacks, as it simply involves combining separate debts into a single, more easily manageable debt. Certain debt relief programs, however, may expose you to potential financial risks, including credit score damage, if you miss a payment or don’t follow the terms of the program. In 2024, household debt including mortgages, credit cards, and loans reached a record high of almost $18 trillion.

• Other companies factor in potential tax savings into the formula.
• As a result, the company effectively only pays $3,500 on its debt.
• You just won’t see a return on this investment until you pay off the debt.
• Cost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability.

To calculate the total cost of debt, you need the value of the total debt, as well as the total interest expense related to the total debt. If you also want to calculate the after-tax cost of debt, you will need the tax rate. When analyzing a company’s financial health, both net debt and the debt-to-equity ratio are crucial metrics to consider. While net debt provides insight into a business’s liquidity position, debt-to-equity ratio highlights its leverage. Both metrics help paint a more comprehensive picture of a company’s capital structure.

• Additionally, the cost of debt can be used to calculate the Weighted Average Cost of Capital, which considers both equity and debt.
• While net debt offers valuable insights into a company’s financial health, it also has some limitations.
• Conversely, a positive net debt figure implies that a firm has more debts on its balance sheet than available cash and liquid assets.
• It considers three factors, i.e., economic fluctuations, a company’s credit rating, and debt usage.
• The first loan has an interest rate of 5% and the second one has a rate of 4.5%.

Hence, for our example, the average weighted interest rate with tax savings factored in is 8.3%. Two standard debt restructuring options are debt rescheduling and debt forgiveness. Debt rescheduling enables companies to modify maturity date, payment schedule, interest rate, or debt currency without reducing the principal amount. Partial or complete debt forgiveness occurs when a lender forgives a part or the entire debt you took. Business owners consider the after-tax amount because of the tax-deductible nature of the interest they pay on loans.

Importance As a Risk Signal

The marginal tax (MTR) rate is the rate on the next dollar/pound/yen of earnings. The agility and adaptability of startups make them well-poised to tackle the challenges of debt management. By integrating the above strategies, not only do you minimize the cost of debt but also solidify your business’s financial base.

You can find total interest expenses on your income statement or tax return. The cost of debt is calculated as the effective interest rate on borrowed funds, adjusted for tax benefits. It is often easier to determine because interest payments are clearly defined in loan agreements or bond terms. First, it can be calculated without factoring in your company’s corporate tax rate, which is referred to as the pre-tax cost of debt figure. If you want to account for the corporate tax savings of your business, you calculate an after-tax cost of debt figure, both of which we discuss below.

It shows you the real expense of your loans, ensuring no financial surprises down the road. This makes it easier to allocate funds effectively and meet all financial commitments. Regulatory bodies in every country set a benchmark interest rate based on economic climate and other factors. The total debt cost can increase or decrease when these interest rates fluctuate. When the interest rate falls, it becomes more affordable to avail loans. While debt fuels business growth, companies must repay the lender, regardless of the financial status of their business.

If your accounts remain past due for too long, your creditor may send them to a debt collector. This may lead to more severe consequences, including legal action. With either strategy, you need to continue making the minimum payments on all your debts. Consistently paying on time over a longer period may improve your credit score. Missing payments due to an aggressive payment schedule may harm your credit. The length of your payment schedule affects the total interest you’ll pay.