Calculating Your Cost of Borrowing
by Angie Mohr on January 14th, 2008
In part one of this article, "Managing Your Small Business Debt", we looked at debt service and the role it plays in your business’s finances. In this article, we’ll look at how you can calculate your cost of borrowing in order to save your business money.
Another useful measure of your company’s debt is to look at the overall cost of borrowing. Comparing the blended cost of borrowing over time tells you whether it is becoming more or less expensive for the company to acquire capital.
You may have financing from several different sources:
* Bank loans
* Lines of credit
* Credit cards
* Capital leases
* Suppliers
* The government
It’s important to understand the total cost of your debt from all sources. You can do this by calculating a blended interest rate from all of your current debt.
Let’s look at an example:
A company has several different sources of financing:
* A bank loan with a current balance of $14,912 and an interest rate of 8.5%
* A capital lease for computer equipment. Balance $5,387. Interest rate 11.4%
* Payroll arrears owed to the government in the amount of $6,754. Interest rate per the statements is 10%
* A corporate credit card with a balance of $12,769. Interest rate 18.5%
In order to calculate the blended cost of debt, we simply divide each interest rate by the proportion of its related debt to the total debt. In the above example, it would look like this:
Type | Amount | % of Total | Interest Rate | Blended
Bank loan | 14,912 | 37.5 | 8.5 | 3.2
Capital lease | 5,387 | 13.5 | 11.4 | 1.5
Payroll arrears | 6,754 | 17.0 | 10.0 | 1.7
Credit card | 12,769 | 32.0 | 18.5 | 5.9
Total | 39,822 | 100.0 | 12.3
The weighted average cost of debt is 12.3% in this example. So, what does this tell us? Not much, by itself. It’s only when we look at the weighted average cost of debt over time that we are able to see if our interest rates are going up or down. If our blended rate is going up, for example, it could mean that we are beginning to have solvency issues. It means that our newer debt is at a higher rate than our existing debt. Lenders may be more hesitant to lend to us and we may be seeking financing from more unconventional (and more expensive) sources.
The Danger of Leverage
Many "Make Millions with Your Small Business" books will talk about leverage and "good" debt versus "bad" debt. They argue that it takes money to make money and that virtually all companies borrow. "Good" debt (they say) allows you to leverage your funds to earn more income. For example, if you can attract $50,000 worth of new business by buying a $30,000 machine on credit, you would be farther ahead to do so.
What these "gurus" don’t tell you is this simple fact:
DEBT = RISK
Not exactly rocket science, I grant you, but critical information to keep in mind, nonetheless. In our above example, what happens if you don’t get the increase in business you were expecting? The debt is still there. You can’t tell the bank "Sorry, I can’t pay you back until I get this new business in the door." When your business is indebted to a bank, mortgage company or other lender, there is the risk of default and of the debt being called and company assets seized. Think of it this way: it’s only companies that have debt that declare bankruptcy. If you didn’t have any debt and you wanted to wind up your company, you would simply close the doors.
Another danger that many small business owners don’t think about is that many lenders require the personal guarantees of company owners and may even require you to put up your home as security. Now, not only are your business assets at risk but everything you own personally as well. Clearly, this increases the risk of entering into credit agreements.
I’m certainly not recommending that you never borrow money. However, you need to understand the following every time you engage in credit:
* What is the purpose of this borrowing?
* Am I getting the best interest rate possible?
* What does the revised stream of cash flows look like with the new debt?
* Do I have a plan to retire this debt?
* Do I have to pledge any personal assets to get this credit?
Once you have satisfied yourself that you have done the required background work to understand your business strategy, then you can enter into the agreement with confidence.
