Cost of debt: What it is and how to calculate

For startups, capital is the fuel that drives innovation and expansion. But when that capital is borrowed, it comes with a price. Grasping the cost of debt — the true expense of your borrowed funds — can steer your business towards smart financial decisions and away from potential pitfalls.

Think of the cost of debt as a financial compass for your startup. It's more than just a number; it's a tool to help make informed choices. Knowing your debt cost helps with accurate budgeting. 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.

In this guide, we'll explore what the cost of debt is, why it matters, and how to calculate it.

Cost of debt 101

In the initial stages of a startup, founders often juggle numerous responsibilities, from product development to customer acquisition. Amidst this whirlwind, understanding financial concepts like the cost of debt financing and capital structure can fall by the wayside. But, if you've borrowed or plan to borrow, grasping this metric is non-negotiable.

What is cost of debt?

The cost of debt, at its core, represents the effective interest rate a company effectively pays on its borrowings. Whether through bank business loans, bonds, or other financial instruments, this cost can impact a company's profitability and financial flexibility.

Importance of cost of debt for businesses

The cost of debt influences multiple facets of a business, from budgeting to decision-making. While excellent management of debt can reduce financial risk and provide access to necessary resources, a lack of understanding can cripple cash flows and stifle growth. Statista reports that 17% of small and medium-sized businesses carry debt between $100,000 and $250,000. 26% of similar-sized businesses report no debt. It's up to you to determine the right balance of debt to carry based on your understanding of how much the debt costs your business.

Impact on financial health

High-interest liabilities can eat into profit margins, restrict cash flows, strain your startup's resources, and make your financial statements unattractive to potential investors. These can limit the capacity to reinvest in the business, hamper the agility to pivot in response to market changes, or even affect routine operational expenses.

Debt management strategies

Effective financial management isn't solely about acquiring capital but optimizing its cost. This might involve loan refinancing to secure lower annual interest rates, debt restructuring to ensure manageable repayment schedules, or timely repayments to maintain a favorable credit history. Each of these strategies can impact your cost of debt and improve your financial health if employed correctly.

Components of cost of debt

While 'interest' might be the first term that pops into mind when thinking of debt, there are multiple facets to consider. By dissecting these, business owners can better predict and manage their financial commitments.

Interest rate

Interest rate is the periodic percentage of the principal (the loan amount) you owe to your debt holders. This rate can be fixed, variable, or hybrid, depending on your agreement. In general, it's the most significant component of your cost of debt.

Additional costs

Other costs can be cloaked under terms like 'service fees,' 'processing charges,' or 'closing costs.' These might seem negligible but can accumulate over time, affecting the overall cost of your debt. If possible, negotiate or compare these costs between lenders or types of debt.

How to calculate the cost of debt

Calculating the cost of debt is akin to assembling a financial jigsaw puzzle: get the pieces right, and the picture becomes clear. Get them wrong, and you might have a distorted view of your debt's actual cost. While you can use cost of debt calculators to help you, here are the core components you'll need to consider:

Formula for cost of debt

Cost of Debt (CoD) = (Interest Expense / Total Debt) x 100

Step-by-step calculation guide

1. Identify your Interest Expense: Check your financial statements, usually under 'Interest Expense.'
2. Determine your Total Debt: Tally all your borrowings.
3. Apply the Formula: Let's illustrate the cost of debt formula with an example. If your annual interest expense is $5,000 and your total debt stands at $50,000:

CoD = ($5,000 / $50,000) x 100
CoD = 0.1 x 100
CoD = 10%

Your Cost of Debt is 10%. This means for every dollar of outstanding debts, you are paying ten cents as interest annually.

Formula for After-Tax Cost of Debt:

After-Tax Cost of Debt (ATCoD) = Cost of Debt (CoD) x (1 - Effective Tax Rate)

The Rationale:
Debt often carries an advantage: the interest can be deducted from your startup's taxable income. This leads to a reduction in the overall tax cost. When we adjust for this using the effective tax rate (which considers the actual tax rates paid on taxable income), we can determine the true cost of debt after tax deductions.

Example Breakdown:

1. Calculate the Cost of Debt (CoD): From our earlier example, an annual interest expense of $5,000 on a total debt of $50,000 gives a CoD of 10%.
2. Determine the Effective Tax Rate: If your startup faces a corporate tax rate of 30%, but thanks to specific deductions and credits, the effective tax rate is 25%.
3. Calculate After-Tax Cost of Debt:
   ATCoD = CoD x (1 - Effective Tax Rate)
   = 10% x (1 - 0.25)
   = 10% x 0.75
   = 7.5%

In this scenario, while the unadjusted cost of debt is 10%, the actual cost after accounting for tax savings is 7.5%. More complex mathematical components, such as credit spreads and the risk-free rate, can also be added to the formula for a more accurate calculation of the after-tax cost of debt.

Factors affecting the cost of debt

Debt isn't static. Various external and internal elements can influence its cost, requiring founders to be proactive and informed. For startups, this knowledge can empower you to strategize better and minimize your borrowing costs. Here's a look at some of these factors:

Credit rating

Your startup's credit rating is akin to a school report card but for your financial health. Lenders scrutinize it to gauge the risk associated with lending to your business.

• Understanding the Rating: Credit ratings are determined by agencies that evaluate a company's financial stability. The better your financial health, the higher your rating. A high rating signals to lenders that the risk of default is low, making them more inclined to offer loans at competitive rates.
• Influence on Cost: The correlation here is direct. A stellar credit rating can pave the way for lower interest rates, translating to reduced borrowing costs. Conversely, a poor rating can see your startup grappling with higher rates, escalating your debt costs.
• Improvement Strategies: Enhancing your credit rating is an ongoing process. Regularly servicing debts, showcasing consistent revenue growth, and maintaining healthy financial metrics can boost your rating over time.

Market conditions

The broader economic environment and prevailing market conditions are dynamic elements influencing the cost of debt.

• Economic Indicators: Parameters like the federal funds rate, inflation rates, and the overall health of the economy can dictate interest rate trends. A booming economy might lead to increased lending but also potentially higher interest rates to temper inflation.
• Supply and Demand: Just like any marketplace, the loan market is driven by demand and supply. When there's an influx of businesses vying for loans, interest rates might inch upwards. Conversely, when lenders are eager to push out capital, they might offer more attractive rates.

Type of debt instruments

Not all debts are created equal. The instruments you opt for can have distinct terms, influencing the overall cost.

• Bonds: These are fixed-income securities where you're essentially borrowing from bondholders. Depending on the bond's terms and your startup's creditworthiness, interest rates can vary.
• Term Loans: Typically, these are loans with a clear tenure. The interest could be fixed or variable, impacting the overall cost over the loan's lifespan.
• Convertible Debt: This is a short-term debt that converts into equity. While it might offer lower interest rates initially, there's the potential cost of equity (equity dilution) to consider in the long run.
• Lines of Credit: These revolving credits provide you with a preset amount of capital to dip into when needed. The interest here is variable, making it potentially tricky to budget for.

Practical applications of cost of debt

When considering growth or big investments, the cost of capital helps answer important questions. Is it the right time to borrow? What will be the financial ramifications in the mid-to-long term? How will this financing round affect the bottom line and the balance sheet? Is our debt-to-equity ratio still within a safe threshold?

With a clear view of debt costs, these decisions can be made with precision, minimizing risk and maximizing your rate of return. In other cases, you may have to decide whether equity cost is better than debt cost. Knowing your debt cost lets you make informed comparisons, even though the terms of venture capital, venture debt, and bank loans are vastly different. Ultimately, it's about finding the right balance between equity capital and debt capital that best suits your business needs.

How to reduce the cost of debt

Managing your debt efficiently not only shores up your startup's financial foundations but also unlocks capital that can be directed toward growth. Here's how to reduce debt costs:

• Debt Refinancing: Swap your current high-interest debt for a loan with a lower rate. Monitor market rates and your startup's credit to find refinancing chances. This is usually less expensive than equity financing.
• Debt Consolidation: Merge multiple debts into one. This not only simplifies repayments but could also offer a lower average interest rate.
• Credit Rating: A good credit score can get you better borrowing terms. Pay bills on time and control costs to boost your score.
• Talk to Lenders: Your relationship with lenders is a two-way street. If your startup is growing or has improved financially, negotiate for better loan terms.
• Alternative Financing: Consider options beyond traditional loans. Think about venture capital, crowdfunding, grants, or invoice financing.
• Operational Efficiency: Streamline processes to cut unnecessary costs, which can help better manage debts.
• Risk Management: Prepare for unexpected challenges. Use strategies like diversification and insurance to ensure market changes don't increase your average cost of debt.

Continuously monitor and manage your cost of debt

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.

It's important to remember that in the dynamic world of startups, debt isn't just a liability; managed wisely, it can be a strategic tool propelling growth. As you journey forward, keep a vigilant eye on your debt metrics and continually adapt your strategies to ensure that you harness debt's potential while keeping its costs in check.