What is the cost of capital in business and why is it important?
Find out more about the different investment strategies available to you and learn about the cost of capital as you build your business. Discover:
- What is the cost of capital in business?
- Why calculating the cost of capital matters
- What to consider when determining the cost of capital
Financial terms shouldn’t be a hurdle for new business owners. Read on to find out more about the cost of capital and how Countingup can help you manage it better.
What is the cost of capital in business?
When starting out, many new business owners need capital to fund their ventures. ‘Capital’ in this context typically means money and, depending on your business, can be secured via debt and equity.
Sourcing capital (money) via debt is a typical route for early businesses, both with sole traders and company directors. It involves taking out loans for the business at a certain interest rate which you pay back over time. The exact interest figure will depend on which type of loan it is (secured, unsecured, personal/business, etc.), who the provider is (such as a bank or government) and your credit history. A long history with a proven track record of managing credit well will help reduce your interest rate. If you don’t yet have a strong credit history, consider different ways you can build your credit score by reading our article Can I get a business loan with bad credit?
In contrast, capital can also be secured by selling equity, or shares in the business’ future profits, to interested investors. This financing option is only available for companies (as they have equity to sell in the first place) and not sole traders. You can read more about the differences in how each type of business operates in our article How to set up your business: Sole trader or limited company.
Therefore, the cost of capital is the money a business pays (whether in additional interest or by diluting its share in future profits) in order to access the money it needs to build.
You can read more about different ways to finance your new business and how this impacts the cost of capital in our article How to finance a business.
Why calculating the cost of capital matters
Calculating the cost of capital is important for small businesses as it can help you decide whether certain business decisions are worth it. The gains in profit you make have to be higher than the cost of capital in order for the investment to be worth it.
In researching your options on different sources of capital (loan type, interest rate and equity sale), you can begin to weigh your options to determine which route will maximise your profits.
What to consider when determining the cost of capital
Calculating the cost of capital to your business will depend on the type of financing method you use (debt or equity) and can include both.
For example, if you’re considering debt from different lenders or types of loans, you can analyse different interest rates or term lengths and how they affect your profits. You may find the cost of borrowing capital may be lower if you choose a higher interest rate but pay it back quicker than if you go for a longer term length on a lower interest rate. Generally speaking, the cost of capital from debt can be lower since interest rates can be expensed in your taxes. However, loans can be risky for your business because the cost of capital is guaranteed: companies and sole traders are obligated to pay lenders back even if the investment fails or profits are lower than expected.
Contrastingly, if you run a company, it may be safer to sell equity to investors as you can avoid financing your business with debt and only pay back investors with profits once you have them. This option still comes with risk as negotiating equity amounts versus the share prices can be difficult. Investors want to buy as much equity as possible in businesses for the least amount of money, while you want the opposite. Therefore, debt financing may be more attractive as it gives you control over company finances and strategy in different ways.
Companies can use both debt and equity strategies for financing their business if the sums they are trying to raise are especially high. Using a blended approach may also save them money.
Calculating the cost to capital in this example is a little more difficult because debt values are more stable, while equity values can vary. In order to calculate the cost of capital to your company, you can use the WACC (weighted average cost of capital) formula. There are a number of free online calculators available that can help you find WACC values without having to run the calculations yourself.
Understand your business’ capital better with Countingup
Projecting the cost of capital for potential investments in your business is a vital financial tool that can save you money. These calculations, along with maintaining financial records more broadly can be useful but time-consuming tasks for new business owners. Use Countingup to save time and stress on your financial admin and understand your business’ capital better.
Countingup is the business current account and accounting software in one app. With all your financial information in one place, you can see your business’ performance in real-time with live profit and loss statements. This way, you can better understand your capital investments faster and with more insight.
The simple app helps you make sure your account records are always up to date and accurate with helpful reminders, a receipt capture feature and automated invoicing.
Find out more here and sign up for free today.