Many companies incur debt in order to finance their operations, whether it's through a bank loan or by issuing bonds in the public credit markets. For investors, it's important to know how much a company has to pay in interest in order to maintain its debt. Often, companies will report the total amount of interest they had to pay on their debt, but in some situations, what you'll see on a financial report is the net interest reduced by the value of the tax deduction the company received on its debt payments. In that latter case, you'll need to figure out the company's pre-tax cost of debt to have a full picture of its finances. Below, you'll find three ways to calculate that cost.
1. Look at the company's outstanding debt directly.
Many companies give a detailed accounting of their outstanding bonds and other long-term debt in the financial statements they're required to disclose every quarter. By looking the details of those debt securities, you can calculate how much interest the company incurred for each.
For instance, if a company has a $100 million bond issue with a coupon rate of 5%, then it will pay $100 million times 5% or $5 million annually on the debt. If you do the same thing for each outstanding debt issue, you can add up the results and get a total amount for the company as a whole.
2. Take a look at the cash flow statement.
Some companies will use after-tax metrics on their income statements while reflecting the pre-tax money movements related to interest expense on their cash flow statements. If that's the case, you might see an adjustment on the cash flow statement directly related to interest expense. Add the adjustment to the after-tax measure, and you'll have your pre-tax figure.
3. Use the overall effective tax rate.
Even if the company doesn't offer you all the details necessary to calculate the pre-tax cost of debt directly, you can still get a back-end number by looking at the company's effective tax rate. Start by subtracting the tax rate from 1, and then divide the after-tax cost of debt by the result. That should give you a good estimate of the pre-tax cost of debt, although because it uses average effective tax rates rather than the company's marginal tax rate, it might not be entirely accurate in reflecting the true debt costs involved.
Figuring a percentage after-tax cost of debt
These methods will give you a total dollar amount that the company is paying in interest. Sometimes, though, you want to know the cost of debt to calculate a cost of capital ratio. To do so, just divide the pre-tax cost of debt by total debt outstanding. That will give you a percentage that tells you the average interest rate the company paid on its debt that year.
Debt plays a vital role of how many companies operate, but knowing what you're paying in interest on that debt is crucial. Calculating pre-tax debt cost gives you a useful piece of information in evaluating a company.
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