Mastering Your Business' Finances: How to Calculate Cost of Debt Accurately

In August 2023, the Bank of England raised the base interest rate to 5.25%—the highest in over a decade. For UK businesses, this signals a clear shift: borrowing is becoming more costly.

So, what exactly is the cost of debt? In simple terms, it’s the interest you pay on any money your business borrows, whether it’s a loan, credit line, or bond. And it matters. Why? Because it directly affects your cash flow, profitability, and overall financial health.

Sure, debt can be cheaper than equity (thanks to tax-deductible interest payments), but it also comes with regular repayments—whether your business is booming or not.

That’s why understanding your cost of debt is so important. It helps you decide when to borrow, how much to borrow, and how to manage the risk.

In this article, we’ll break down how to calculate the cost of debt and explore the factors that affect it, so you can borrow money for your business with confidence.

Key Takeaways

• Understanding the true cost of your debt helps you make smarter decisions and keep your business financially healthy.
• Credit rating counts, as a higher credit score means lower interest rates. Keep that rating strong to save on borrowing costs.
• Watch market trends. Interest rates and inflation can change your borrowing costs. Stay ahead of the curve by keeping an eye on market conditions.
• Not all loans are the same. Pick the type of debt that fits your needs to avoid paying more than you should.
• Interest payments are often tax-deductible, cutting down your real cost of debt—but don’t forget to manage the risks.

All About the Pre-tax Cost of Debt

The pre-tax cost of debt represents the interest rate your business pays on loans and borrowings—before factoring in any tax benefits.

It’s a simple way to see exactly how much your debt is costing you, giving you a clear snapshot of your financial health.

Your pre-tax cost of debt tells you exactly how much you’re paying to keep up with your loans.

This number helps you decide whether taking on new debt is a smart move or a costly mistake by comparing the cost of borrowing with the expected returns.

Plus, it’s critical to figure out your company’s Weighted Average Cost of Capital (WACC), a key metric that informs major investment and growth decisions.

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Let’s break it down:

• Interest Expense: This is all the interest you pay on loans, bonds, and other borrowings, both short-term and long-term. You can usually find this on your income statement.
• Total Debt: This is the total amount your business owes, including both long-term loans and short-term liabilities like credit lines. For the most accurate number, average your debt at the start and end of the year.

So, if your business has an annual interest expense of £60,000 and a total debt of £1,200,000, your pre-tax cost of debt would look like this:

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This means your business is paying 5% in interest on its total debt before tax benefits kick in. 

Now, let’s jump into how tax benefits change the picture.

Calculating the After-Tax Cost of Debt

The after-tax cost of debt is the real interest rate your business pays after factoring in the tax benefits from interest payments. Most businesses can write off these payments, which brings down the real cost of borrowing.

This little tax perk, also known as the interest tax shield, is what makes debt such a smart financing choice. By lowering the real cost of borrowing, it allows you to leverage debt more efficiently. 

Understanding your after-tax cost of debt is crucial for optimizing your financing strategy. It helps you take full advantage of tax benefits while ensuring your borrowing remains cost-effective.

Effective Tax Rate

Your effective tax rate is the percentage of your earnings before tax (EBT) that goes to taxes.

This is important because it tells you how much of your interest payments are giving you a tax break.

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Calculating the After-Tax Cost of Debt

To figure out your after-tax cost of debt, just use this formula:

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This formula takes the pre-tax cost of your debt and adjusts it based on your tax rate, giving you the real cost after you account for the tax savings.

For example, if your pre-tax cost of debt is 6% and your effective tax rate is 30%, here’s what it looks like:

After-Tax Cost of Debt = 6%  (1 − 0.30) = 4.2%

So, thanks to that tax break, you’re effectively paying just 4.2% in interest!

How Tax Rates and Interest Rates Affect the After-Tax Cost of Debt

When tax rates go up, your after-tax cost of debt goes down—because the tax shield becomes even more valuable. 

But if tax rates fall, your after-tax cost of debt rises because you’re losing part of that benefit.

Interest rates also matter. Higher rates mean higher borrowing costs across the board, while lower rates make debt cheaper, both before and after taxes.

Practical Implications

Your after-tax cost of debt has a big impact on your business decisions, especially when it comes to investing and managing capital. 

A lower after-tax cost of debt can reduce your overall cost of capital, which gives you more room to grow and increase profitability. Here’s what you should keep in mind:

• Strategic Debt Management: When tax rates are high, borrowing becomes more attractive. But if tax rates drop, you might want to rethink your strategy.
• Debt Refinancing: When interest rates go down or your credit improves, refinancing your debt can lower both pre-tax and after-tax costs, giving you more flexibility.
• Global Operations and Effective Tax Rates: If you’re operating internationally, borrowing in countries with favourable tax rules can help you maximize your tax benefits.
• Inflation’s Impact: Higher inflation usually means higher interest rates, but it can also erode the real value of your debt over time, offering some relief.

Knowing your after-tax cost of debt is crucial to making smarter financial decisions, whether you're managing current debt or planning to borrow in the future.

FundOnion offers you transparent, real-time comparisons, helping you find the best funding options for your business—quickly and confidently.

How to Calculate the Cost of Debt: Methods Every Business Should Know

Understanding your business’s cost of debt is crucial for smart financial management.

Whether you’re looking to take out a loan, issue bonds, or manage multiple credit lines, knowing how to calculate the cost of debt can significantly impact your financial strategy.

Let’s explore the most common methods, so you can find the one that works best for you.

Yield to Maturity (YTM) Approach

If your business has publicly traded bonds, the Yield to Maturity (YTM) method is the way to go.

YTM is essentially the total return bondholders expect if they hold the bond until it matures, factoring in interest payments and the bond’s final value. It’s the most accurate way to calculate your cost of debt when you have clear market data.

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Let’s say you’ve issued a bond with a face value of £1,000, currently trading at £950, with 5 years until maturity and a 5% annual coupon rate. The YTM would be:

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Credit Rating Approach

Don’t have publicly traded bonds? No worries! You can use the credit rating approach. 

This method estimates your cost of debt based on your credit rating. Agencies like Moody’s or S&P assign these ratings, and the lower your rating, the higher the interest rate—because lower ratings mean higher perceived risk.

How to calculate the cost of debt:

1. Find your company’s credit rating (e.g., AAA, AA, BBB).
2. Check the average yield for bonds with the same rating and maturity.
3. Adjust for any specific factors like your company size or industry risk.

A BBB-rated bond generally has a higher cost of debt than an AA-rated bond because the risk of default is higher for lower-rated companies.

Risk-Free Rate Plus Credit Spread

If your bonds aren’t actively traded but you still have access to market data or a credit rating, this is another solid option.

The Risk-Free Rate Plus Credit Spread method works by adding a credit spread (the difference between your bond and a risk-free asset like UK government bonds) to the risk-free rate.

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If the current risk-free rate is 2% (based on UK gilts) and your credit spread is 3%, your cost of debt would be:

Cost of Debt = 2% + 3% = 5%

Synthetic Rating Approach

No official credit rating? No problem! You can estimate your cost of debt using the Synthetic Rating Approach, which looks at your company’s financial health compared to similar businesses.

One key tool here is the Interest Coverage Ratio (ICR).

How to calculate the cost of debt:

1. Calculate your Interest Coverage Ratio (ICR).

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2. Compare your ICR to industry benchmarks to estimate a credit rating.

3. Use that rating to find the average yield for similar bonds and calculate your cost of debt.

If your ICR is 4, you might get a synthetic rating of BBB. Naturally, a BBB rating will result in a higher cost of debt than, say, an AA rating.Weighted Average Cost of Debt (WACD)If your business has multiple sources of debt, things can get a bit more complex. That’s where the Weighted Average Cost of Debt (WACD) comes in. This method calculates the average interest rate on all your debt, weighted by how much each type of debt contributes to your total borrowing.

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If you’ve got £500,000 of debt at 4% interest and £300,000 of debt at 6%, the WACD would look like this:

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Whichever method you choose, understanding your cost of debt is essential to making smarter financial decisions.

And at FundOnion, we make it easy.

With transparent comparisons tailored to your business, you can explore your funding options in just 90 seconds or less.

Ready to find the best deal for your business? Let’s get started!

Breaking Down the Factors Shaping Your Cost of Debt

Now that you know how to calculate your cost of debt, it’s time to learn what affects it.

When you're borrowing for your business, several factors can either push your costs up or help bring them down. Let’s walk through the important factors so you can stay in control of what you pay.

1. Credit Rating

Your credit rating is like your business’s report card, and it’s a big deal when it comes to borrowing. Agencies like Moody’s or Standard & Poor’s assign these ratings, which tell lenders how risky you are as a borrower.

• High Credit Rating (AAA or AA): You’re looking good! Lenders see you as low-risk, which means they’re likely to offer lower interest rates.
• Low Credit Rating: Not as shiny. If your rating is on the lower side, lenders will charge higher rates to cover the added risk. Keeping that credit score strong can largely cut your borrowing costs.

2. Market Conditions

The happenings in the economy can have a huge impact on what it costs to borrow money.

• Economic Trends: Interest rate hikes and inflation can push borrowing costs higher. When rates go up, borrowing becomes more expensive. But in tougher times, like during a recession, rates might drop, making borrowing cheaper.

Supply and Demand: The market decides everything. If everyone’s scrambling to get a loan, lenders might raise rates. On the flip side, more competition between lenders can work in your favour and help bring rates down.

3. Type of Debt

Not all debt is created equal. The type of loan or financing you choose can have a big impact on your costs. Let’s have a look at some of the popular types of debt:

• Bonds: Bonds typically come with lower rates, but your credit rating will still play a big role in the final number.
• Term Loans: These loans have fixed interest rates and set repayment periods. The rate you get is going to depend a lot on your creditworthiness.
• Convertible Debt: While convertible debt may offer lower interest rates upfront, it comes with a twist—it can convert into equity, which adds some complexity to the cost.
• Lines of Credit: Perfect for short-term borrowing, but keep an eye on those variable interest rates! They can change with the market and make your costs unpredictable.

4. Debt Term

How long you have to pay off your debt matters, too.

Remember: Longer Terms = Higher Costs.

The longer the repayment period, the higher the interest rate. Why? Lenders see long-term loans as riskier, so they’ll charge more to balance out that risk.

5. Financial Health of Your Business

How solid is your business? If your financials are strong, lenders will see you as a safer bet, and that can lower your costs.

If your revenue is stable, your cash flow is healthy, and your profitability is solid, lenders are more likely to give you favourable rates. But if your earnings are unpredictable or you’re already carrying a lot of debt, expect those borrowing costs to go up.

6. Tax Implications

A perk of borrowing is that the interest payments are usually tax-deductible, which lowers your actual cost of debt.

By deducting the interest you pay on loans from your taxable income, you effectively reduce what it costs to borrow. That’s one of the reasons businesses often choose debt over equity since dividends paid to shareholders don’t get the same tax break.

But there’s a caveat. Sure, debt comes with tax advantages, but it’s important to balance those savings with the risks of taking on too much debt.

Ready to Lower Your Cost of Debt? Here’s How.

Want to reduce your borrowing costs and keep your business finances in check? These simple, effective strategies can help you lower your cost of debt to keep more money in your business:

1. Boost Your Credit Rating

Your credit rating plays a huge role in the interest rates you get, and improving it can go a long way in lowering your borrowing costs. Here’s how:

• Check In Regularly: Keep an eye on your credit score and reports. Catching errors early can help you avoid any surprises when it comes time to apply for a loan.
• Manage Your Credit Utilization: Keeping your credit utilization ratio low—under 30% is ideal. This shows lenders you’re managing credit responsibly, which can help improve your credit score and get you better rates.

2. Negotiate Like a Pro

Negotiating your loan terms can make a large difference in what you pay:

• Know Your Priorities: Whether you’re aiming for a lower interest rate or longer repayment terms, understanding your goals—and the lender’s—can help you negotiate terms that work for you.
• Compare, Compare, Compare: Don’t settle for the first loan offer. Shop around to find lenders who are offering the best rates and terms. You’ll be surprised how much you can save by simply comparing your options. Use FundOnion’s prompt services to find an exhaustive list of lenders to choose the best one!

3. Use Tax Deductions to Your Advantage

Interest on your debt is usually tax-deductible, which lowers your actual borrowing cost. Here’s how you can use that to your advantage:

• Make the Most of Deductions: Those interest payments are tax-deductible, so make sure you’re maximising your savings by factoring this in when managing your debt.
• Plan for the Long Term: Don’t just look at the here and now. Think about how these tax savings fit into your broader debt strategy and use them to your advantage over time.

4. Offer Collateral for Lower Rates

Got valuable assets? Use them as collateral to secure better interest rates.

Lenders often offer lower interest rates for loans backed by assets, like property or equipment. It reduces their risk, and you get a better deal. If you’ve got collateral, it’s worth considering.

5. Explore Other Financing Options

Sometimes, finding a different way to manage your debt can make all the difference:

• Consolidate Debt: If you’re dealing with multiple high-interest loans, consolidating them into one lower-interest loan can save you money and simplify your payments.
• Try Balance Transfers: If credit card debt is a concern, balance transfer cards with low or zero interest for an introductory period can help you pay off what you owe faster and with less interest.

6. Pick the Right Repayment Strategy

The way you choose to repay your debt can have a big impact on how much you pay in interest over time. The following strategies will help:

• Avalanche Method: Focus on paying off the debts with the highest interest rates first. This method saves you the most in the long run.
• Snowball Method: If you need a quick win, start with your smallest debts. Paying them off first helps build momentum, which can keep you motivated as you tackle the bigger ones.

7. Review and Adjust as You Go

Your financial situation isn’t set in stone, and neither is your repayment strategy.

Regular financial reviews can help you adjust your loan terms, interest rates, and repayment strategies as your business needs change. 

Keep an eye on your finances and make sure your debt management strategy evolves with your business.

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The Bottom Line on Cost of Debt

Managing your cost of debt is crucial for keeping your business financially healthy. By calculating and understanding your borrowing costs, you can make smarter decisions, balance debt, and avoid paying unnecessary interest.

That’s where FundOnion steps in. 

We get it: traditional funding options can be slow and complicated. With FundOnion, you can find your perfect lender quickly and easily. 

In just 90 seconds, you’ll get transparent, real-time comparisons from a range of lenders, making it simple to lock in the best deal for your business.

No hassle, no confusion—just clear options tailored to your needs. Ready to find your perfect lender? Get started and discover how much your business can borrow today!

FAQs

1. How does a company’s credit rating affect its cost of debt?

A strong credit rating means lower risk for lenders, so businesses with high ratings (like AAA or AA) enjoy lower interest rates. Conversely, a lower rating signals higher risk, leading to higher borrowing costs. Keep your credit rating healthy to secure better loan terms.

2. What is the difference between pre-tax and after-tax cost of debt?

The pre-tax cost of debt is the interest rate your business pays before tax benefits. The after-tax cost of debt reflects the actual cost after considering tax savings, which lowers the real borrowing cost.

3. How do you calculate the cost of debt for a private company without publicly traded debt?

Private companies often use matrix pricing. This method applies a yield spread over risk-free rates (like government bonds) based on the company’s credit rating, providing a reasonable estimate for borrowing costs.

4. How does market volatility impact the cost of debt?

Market fluctuations, driven by factors like inflation or central bank decisions, can lead to higher or lower interest rates. Rising rates increase your cost of borrowing, while lower rates can make debt more affordable.

What role does the Weighted Average Cost of Capital (WACC) play in evaluating a company’s cost of debt?

WACC represents your overall financing cost, factoring in both debt and equity. Understanding the cost of debt is crucial for calculating WACC, which helps guide investment and funding decisions.

Can companies influence their cost of debt by refinancing?

Yes. Companies can lower their cost of debt by refinancing, especially when interest rates drop or if their credit rating improves. This helps secure better loan terms and reduce overall borrowing costs.

FundOnion makes borrowing easier. Explore your funding options in just 90 seconds!