In the dynamic world of small business, understanding the cost of money is crucial for informed financial decisions. It’s essentially the interest you pay to utilise funds, whether borrowed or your own. Even using your own cash has a cost, as you’re forgoing potential returns from other avenues like savings accounts.

This guide delves into the concept of cost of money and equips you with a simple 4-step method to calculate it for your business. We’ll also explore its practical applications in making strategic financial choices.

Understanding the Cost of Money

Think of the cost of money as the rent you pay for using someone else’s capital, like bank loans, credit cards or even borrowing from friends and family. Many of these sources typically come with hefty interest rates. But even when you leverage your own funds, there’s an opportunity cost involved. The money you invest in your business could have been earning interest in a savings account. This forgone interest becomes your cost of money.

Calculating the Cost of Money in 4 Steps

To determine your business’s cost of money, follow these straightforward steps:

Step 1: Identify Your Funding Sources

List all the ways your business acquires funds. This might include:

• Small business loans
• Credit cards (individual balances, not limits)
• Investments from friends or family (even if interest-free)
• Business transactional and savings account balances

Step 2: Assign Interest Rates

For borrowed funds like loans and credit cards, find the corresponding interest rates (these can be found in your originating documents or on your monthly statements).

Step 3: Apply Positive or Negative Signs

• Use a “+” sign for borrowed funds (sources from which you’ve “taken” money i.e. a bank loan)
• Use a “-” sign for deposited funds (sources where your business has “put” money i.e. money from your savings account).

Step 4: Calculate the Weighted Average

• Multiply the amount in each funding source (Column A) by its corresponding interest rate (Column B).
• Apply the positive or negative sign from Step 3 (Column C) to get the weighted value.
• Add all the values in Column A (total funding) and Column D (weighted values).
• Divide the total funding (Column A) by the sum of weighted values (Column D). The result is your cost of money as a percentage.

Example

Based on the table above:

The Cost of Money = R 48 505 / R 310 000 = 15.65%

This means the average interest rate you’re effectively paying for your business capital is 15.65%.

Applying the Cost of Money

Understanding your cost of money empowers you to make informed financial decisions. Here’s an example:

Early Payment Discounts: Many suppliers offer discounts for early payments. By comparing the discount to your cost of money, you can determine if settling early is financially beneficial. If the discount exceeds your cost of money, it might be wise to take advantage of it.

By regularly calculating your cost of money, you gain valuable insight into the true cost of financing your business. This knowledge can empower you to optimize your finances and make strategic decisions that fuel your company’s growth.