A common practice for companies to obtain funding for future growth is through the use of debt. In corporate terms, debt can take many forms. Many investors think that the amount of debt is the key indicator of a company’s financial health, but the real indicator that investors should be concerned about is the cost of debt.
The cost of debt essentially is an indicator of how much it costs a company to service their debt. In this article, we'll define the cost of debt, explain where it fits into a company's capital structure and review several formulas for calculating the cost of debt, and how the individual components that make up the cost of debt calculation can affect a company's overall cost of debt.
What is cost of debt?
In its simplest form, cost of debt is the effective interest rate that a company will pay on all of its debt obligations. The cost of debt is expressed as a percentage. A company’s cost of debt, along with their cost of equity, are the two components of their capital structure. A company’s capital structure shows how a company finances both its operating costs and its growth using different sources of funds. The most common funding sources a company uses to finance debt are issuing shares (i.e. equity capital) or by issuing bonds or loans (i.e. debt equity). The cost of equity (also called return on equity) gives a picture of how efficiently a company uses shareholder equity while the cost of debt shows how efficiently a company is able to service its debts.
How is the cost of debt different from the cost of equity?
As mentioned above, cost of equity (also called return on equity) comes from shareholders. The distinguishing feature of this debt is that, while it does not need to be repaid, it comes with an expectation that investors will receive a return on their investment. This will either come by an increase in share price and/or through a regular and hopefully rising, dividend payment. Cost of equity provides a snapshot of how well a company can generate profits from the equity they receive from shareholders. In general, if a company has a return on equity of between 15% and 20% (meaning they are making $0.15 to $0.20 for every dollar of shareholder money), they are growing.
Cost of debt, on the other hand, must be repaid. Debt equity provides a company with the ability to leverage a small amount of money into a much greater amount. However, by allowing a company to borrow this money, the lenders expect to receive a return of their principal with interest.
There are times and a variety of reasons that a company may choose one form of financing over another. However, in general, the cost of equity will exceed the cost of debt. This is due to the risk that shareholders carry since companies are not required to repay shareholders and shareholders can lose their entire investment (i.e. their shares become worthless) if the company comes becomes insolvent.
How do you calculate cost of debt?
The basic formula for calculating the cost of debt is:
Total interest on debts for a year/Total debt
Here’s a basic example to illustrate the formula. In this example, a company has a $2 million loan with a 5% interest rate, a $400,000 loan with a 7% interest rate and they have issued an additional $2 million in bonds at a 6% rate. The interest rate on the loans calculates out to be $100,000 and 28,000 respectively. The bond interest calculates out to $120,000. The total debt is 4,400,000. Using the formula, this company’s cost of debt is as follows:
(100,000 + 28,000 + 120,000)/4,400,000 = 0.056 or 5.6%
What does cost of debt say about a company’s financial health?
In personal finance, we think about the cost of debt when we look for loans to finance a home, pay for school, or perhaps to finance a home renovation. We also do, or should, pay attention to the interest rate charged on other debt instruments like credit cards. Since this is not a personal finance article, we'll set aside the issue of good versus bad debt, but we understand that a low amount of debt with a high interest rate can be just as bad, and typically worse, than a higher amount of debt financed at a low-interest rate.
It’s the same for a business. Businesses take on debt for a variety of reasons, and many of them are for viable reasons. In some cases, a company may choose to issue shares of stock in what is called equity financing. In other cases, they make take on debt. In both cases, it’s not necessarily the amount of debt they assume, but how confident investors are that the debt will be paid back while still allowing the company to have operating capital.
In general, when a company has a high cost of debt (particularly when it’s higher than comparably sized companies and/or other companies in their sector, they are considered to be a higher default risk. However, it’s important to understand the reasons behind their cost of debt.
In some cases, a high-interest rate can reflect conditions in the overall economy. In other cases, a high interest rate may be a reflection of a company's overall credit rating (i.e. their worthiness to receive credit). When the cause of high interest rates is a condition of the overall economy, it's less concerning, but if high-interest rates are due to a poor credit rating, that can make the company a default risk.
You can find the information to find a company’s cost of debt from their balance sheet. Under “Current Liabilities” a company will list how much interest they have paid over that time period and how much debt remains. It’s helpful to understand that the cost of debt is a moving number. It can, and will, fluctuate over a period of time. For example, when a company experiences a spike in revenue, they may use some of that revenue to pay down debt more aggressively. In general, you're looking for trends. If the cost of debt is increasing, you will want to conduct due diligence to understand why.
Does the cost of debt express a before-tax rate or after-tax rate?
In our example above, the cost of debt was being expressed before taxes. However, in most cases, a company's cost of debt is expressed as an after-tax rate because any interest payments that are made are tax deductible. Therefore calculating cost of debt after taxes provides a more accurate picture of a company's capital structure. However, when calculating the cost of debt as an after-tax number, the formula is enhanced to take into account not just the interest rate that a company pays on its debt but also its marginal tax rate. The adjusted formula looks like this:
Cost of debt x (1 – tax rate)
In our earlier example, a company that has a cost of debt of 5.6% and a marginal tax rate of 40%. To calculate its after-tax cost of debt, you would subtract 40% from 100% (1 – 0.4) to get an after-tax rate of 60%. Multiplying the cost of debt, 5.6%, by 60% you get an after-tax cost of debt of 3.36%.
What external factors affect a company’s cost of debt?
The primary influencers to a company’s cost of debt are the effective interest rate on their debt(s), their credit spread, and their marginal tax rate. Let’s take a closer look at each of these.
Effective interest rate – The effective interest rate is, in many cases, market-driven. Interest rates tend to go up when the economy is expanding as a hedge against inflation. This obviously makes it more expensive for a company to borrow funds. Conversely, when the economy is slowing down, interest rates tend to fall which makes it cheaper for a company to borrow.
Credit spread– a company’s credit spread is determined both by the amount of debt they are carrying and their credit score. When a company carries a large amount of debt but have a lower credit score it is a signal that they have a greater chance of defaulting on their debt. It's no different than what our credit score as consumers says to potential lenders. When we take on more debt relative to our income, we become a higher credit risk. In the same way, when a company takes on a greater percentage of debt, they can be seen as a higher default risk.
Marginal Tax Rate –The marginal tax rate is another area that can be affected by external forces outside of a company's control. When a government raises the tax rate to ensure their needed revenue stream is met, it can have a negative effect on a company's cost of debt. However, an increase, or decrease, in tax rates will affect like-size companies in similar ways.
The bottom line on cost of debt
One of the most important considerations for investors when deciding whether to invest in a company is how efficiently a company can service its debt. The presence of debt on a company’s balance sheet should not, in and of itself, be alarming. Assuming debt can be an effective way for a company to leverage a small amount of money and turn it into a much larger amount. However, as in our personal financial transactions, investors should pay attention to the cost of that debt as determined by the interest rate they pay.
As with most financial calculations, cost of debt is only one of many metrics that can give investors a view of the financial health of a company. In the case of cost of debt, it should be looked at with cost of equity to get a more accurate picture of the company’s capital structure.
As opposed to raising capital by selling shares (i.e. return on equity), debt-equity must be repaid therefore a company with a cost of debt that is higher to other similar sized companies or other companies in its sector should be concerning as it may indicate that the company will have a difficult time repaying its debt.
The basic formula for determining cost of debt is done on a pre-tax basis. However, most investors are interested in what a company's after-tax cost of debt is because the interest that a company pays on its debt is tax deductible, therefore, the after-tax cost of debt is a more accurate indicator of a company's financial health.
Two external factors that can affect a company’s cost of debt that they have no control of are the direction of interest rates (which is dictated by the economy) and tax rates (which is dictated by government policy). A factor that a company does have control of is its credit spread which is determined by the amount of debt it is carrying and its credit score.