To take advantage of this article to its fullest extent, we recommend downloading the Cost of Debt Calculator
Many small business owners borrow money to start and grow their business. And is often the case those same business owners find themselves hitting credit limits established by banks and other lenders causing enormous growing pains for the business. Simply stated, running out of business capital when you’re growing a business is difficult at best.
Although debt financing offers a business owner the least costly form of capital to grow and maintain a business, a business owner may find himself in a position where his business is growing so rapidly and he’s unable to borrow enough money to adequately finance or capitalize his business. We call this situation hyper-growth and it often forces the business owner to add another form of more expensive (borrowed) capital to the balance sheet.
Before we explore how the cost of debt impacts how a business may grow, let’s establish how to compute its total cost.
Facts and Figures for the Cost of Debt Computation
From the borrower’s perspective, the cost of debt is defined as an annual rate similar to the annual rate of return on an investment in common stock or bonds. In this case, the lender is offering money to the business borrower and receives a rate of return, expressed in an annual timeframe, on its loan.
To compute the cost of debt for the business borrower, you will need to know the following information:
- Interest or Funding Fee charged by the Bank or other Lender (expressed in the form of a % of the amount borrowed).Note whether the interest rate is expressed in a daily, monthly or annual timeframe here: ___________ You will need to know this important fact when you start to compute the total cost of debt.
- Amount of Money Borrowed $_____________
- Application Fee (this fee is typically a flat or stated amount or expressed as a %) $_____________ or _____________%
- Origination Fee (this fee is typically a flat or stated amount or expressed as a %) $_____________ or _____________%
- Idle Usage Fee (this fee may be assessed by the lender if a line of credit is not fully utilized by the business and may be a flat or stated amount or expressed as a %) $_____________ or _____________%
- Early Payoff Fee (this fee may be expressed in a flat amount or in the form of a %) $_____________ or _____________%
Calculate the Cost of Debt for Your Business
Once you’ve identified all of the fees typically associated with borrowed capital, you will be able to calculate the cost of debt. This formula may be used to compare the total cost of borrowed capital between banks and other lenders to identify the least cost alternative.
Download our free workbook and enter in your own facts and figures to compute your cost of debt. The workbook has three examples: One shows all of the various costs a lender may assess; the second is an example of typical Bank Loan costs; and the third is an example of Alternative Lender costs. The workbook also includes several spreadsheets loaded with the formulas and ready for your own data input.
In fact, if you have several banks or lenders offering you a loan or line of credit, this tool may help you understand how the terms offered translate into the true cost of debt in order to determine which lender is making you the best offer.
Despite the fact that debt is typically the least costly form of capital, many business owners are averse to the notion of borrowing money for their business. In many cases, it is because the business owner doesn’t understand the relationship between the cost of debt and the opportunity to grow their business and their profit.
Contrary to what many business owners believe, there are times when it is foolish for a business owner to avoid debt. While that statement may seem very bold, let’s spend some time looking at the cost of debt and how it relates to a few measurements of business profitability so I may explain further.
When a business owner uses debt (or any other form of capital) to grow his business, he should pay attention to the cost of debt (or other capital) as it relates to the business’ gross profit margin and net operating income margin. It is wise to be mindful that the cost of debt (or capital) should not exceed either the business’ gross profit margin or its net operating income margin. To illustrate, let’s review an example and start with the definitions of gross profit margin and net operating income margin.
The Gross Profit Margin is that portion (or percentage) of every sales dollar generated which remains after the direct cost to create the product or service is deducted. If you’re selling widgets for $1.00 and they cost 60 cents to manufacture, then the company’s Gross Profit Margin is $.40 or 40%.
The Net Operating Income Margin is the profit (or percentage) of every dollar in sales generated that remains after the direct cost to deliver the product or services as well as the indirect costs to operate the business are deducted. Indirect costs would be expenses like rent, insurance, professional fees, etc. If you’re selling widgets with a gross profit margin of 40% and your indirect expenses total 21% of sales, then your company’s Net Operating Income Margin (or Net Profit Margin) would be 19%.
Cost of Debt vs. Gross and Net Profit Margins
In the example noted above, a business generating a 19% net operating income margin (or net profit margin) has enough income from every additional sale to justify borrowing money to grow its sales as long as the cost of debt is equal to or less than the net operating income margin rate of 19%.
Similarly, if a business is generating 40% gross profit from every sale and its indirect costs are relatively static, it stands to reason that every additional dollar of revenue could significantly increase the business’ net operating income margin. Accordingly, this reasoning contributes to the theory that may justify a business borrowing money to grow sales at a cost of debt equal to or less than its gross profit margin rate of 40%.
A Few Important Notes Regarding Cost of Debt for the Business Owner
1. Applying the cost of debt analysis is valid when you consider the cost of capital, regardless of its source. In other words, this comparison of the cost of debt to the gross margin and net operating margin is also valid when considering the use of other forms of capital such as mezzanine or equity.
2. Most businesses are unable to sustain in the long term the practice of borrowing when the cost of debt is in excess of 20% simply because they don’t have high gross profit margins nor do they have static operating expenses. On the other hand, a business in certain industries that enjoy a relatively high gross profit margin, is more likely to take advantage of borrowing or financing with relatively more expensive capital.
A business has opportunities to grow its sales by borrowing money to finance the production of products or the delivery of services at a cost of debt which is within the limits of its Net Operating Income Margin, and in certain cases within the limits of its Gross Profit Margin. It’s imperative for the business owner to fully understand the business’ cost of capital before making the decision to grow the business with borrowed or other forms of capital.