Financing Costs

Financing Costs Definition

Financing costs are defined as the interest and other costs incurred by the Company while borrowing funds. They are also known as “Finance Costs” or “borrowing costs.” A Company funds its operations using two different sources:

None of the financings comes as free for the Company. Equity investorsEquity InvestorsAn equity investor is that person or entity who contributes a certain sum to public or private companies for a specific period to obtain financial gains in the form of capital appreciation, dividend payouts, stock value appraisal, etc.read more require capital gains and dividends for their investments, and debt providers seek interest payments.

Finance costs, however, refers to the interest costs and other fees to be given to debt financers. Interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more can be on both short-term financingShort-term FinancingShort-term financing refers to financing a business for less than a year in order to generate cash for working and operating expenses, usually for a smaller amount. It include obtaining funds through online loans, credit lines, and invoice financing.read more and long-term borrowings.

In broader terms, borrowing costs include the following costs other than the interest costs:

Consider the Income StatementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more of Colgate Palmolive

Below we note that the financing cost of Colgate was $143 million and $102 million in 2018 and 2017, respectively.

financing costs example 3

Source:- Colgate

Types of Debt Financing

Let us see various costs included in different types of debt financing:

Financing Costs

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For eg:
Source: Financing Costs (wallstreetmojo.com)

#1 – Short Term Financing

Short term financing includes bank overdraftBank OverdraftOverdraft is a banking facility that offers short-term credit to the account holders by allowing them to withdraw money from their savings or current account even if their account balance is or below zero. Its authorized limit differs from customer to customer.read more. A bank overdraft includes an annual maintenance charge, plus interest on the drawn amount and fees on the non-utilization of funds. The interest charges are varying and increase if the risk to defaultRisk To DefaultDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more increases. A higher rate and fees are charged if the unauthorized facility of limits is utilized.

Business credit cards are used for short term financing. They include annual fees and interest if the payment is not made on time. If the holder of the credit card pays the fees on time, no interest is charged, and only maintenance fees will be charged on the same.

Trade creditsTrade CreditsThe term "trade credit" refers to credit provided by a supplier to a buyer of goods or services. This makes it is possible to buy goods or services from a supplier on credit rather than paying cash up front.read more are very common in businesses. Trade credit involves selling goods and services on credit. Although the seller charges no direct interest or fees, they tend to include the borrowing costs in the cost of goods sold by selling at a higher price. Businesses usually give a discount if payment is made early and the buyer tends to lose the facility if purchased on credit.

#2 – Medium and Long-Term Financing

The primary cost of long term and medium-term financing is interested in charge, and fees are usually taken by the bank when the loan is applied. While the loan application fee is the same, the interest rate charged varies according to the risk profile. It may include if the loan is a secured or unsecured loanUnsecured LoanAn unsecured loan is a loan extended without the need for any collateral. It is supported by a borrower’s strong creditworthiness and economic stabilityread more and type of assets put as collateral in case of a secured loan.

Companies leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”read more a lot of machinery to make it an asset-light model for their business. The cost of hiring/renting includes monthly lease paymentsMonthly Lease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration.read more, which cover the depreciation cost, maintenance costs, and other capital costs. Leasing rates depend on the tenure, cost, and type of asset leased. Assets that have higher resale value will have lower lease ratesLease RatesThe lease rate is the interest rate associated with leasing the asset during the lease period. In simple terms, it is the compensating amount that otherwise the lender would have earned if the same property, equipment, or vehicle would have been up for some other use.read more while the assets which have a lower resale value will have a higher resale rate.

Calculation of Financing Cost with Examples

Usually, borrowing costs are calculated in terms of Annual Percentage rate (APR). Usually, interest rates for finance costs are not published by the Companies. Hence the investors use the following formula to calculate financing costs:

Formula of Interest

Interest = (Total Amount Paid Back – Total Amount Borrowed)/Total Amount Borrowed

However, this method seems easy and simple. It has its flaws as it does not consider the time to pay the loan.

Let us consider that a Company took a loan of $10,000 and paid $11,000 in 3 months.

Calculation of Interest

Finance costs example 1

Interest cost using the above formula is 10%.

However, if the same is annualized and compounded, it is 46%.

While calculating finance costs is one method to analyze the Company, mainly investors are interested in the Company that can service its debt. Hence, they are interested in the Interest Coverage RatioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt.read more.

Interest Coverage Ratio = Earnings before Interest and Taxes/Interest Expense

The interest coverage ratio for the Company can be calculated as

borrowing costs example 2

= 3607 /143

Interest Coverage Ratio = 25.22

Important Points about Borrowing Costs

The investors analyze any change in financing costs, and they seek questions on structural and operational changes happening in the Company, which led to a change in finance costs.

Conclusion

Any type of financing requires the Company to reward the financiers. Equity holders need dividend and capital gains, whereas creditors require fees and interest payments. It includes interest payments and fees which the company pays to the creditors for taking on short-term or long-term financing facilitiesLong-term Financing FacilitiesLong term financing means financing by loan or borrowing for a term of more than one year by way of issuing equity shares, by the form of debt financing, by long term loans, leases or bonds, done for usually extensive projects financing and expansion of the company.read more.

Recommended Articles

This article has been a guide to Financing Costs and its definition. Here we discuss how to calculate financial costs along with practical examples and types of debt financing. You can learn more about financing from the following articles –

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