2 min read
Compares the expected return on what the money funds against the cost of the finance.
Step 1 — estimate the return the money creates
Work out the extra profit the borrowing will generate — new contracts, capacity, stock turned into sales. Be conservative. This is the return on borrowing you are testing against the cost.
Step 2 — find the true, net-of-tax cost
Take the total cost of credit, then reduce it for tax relief, since interest is usually deductible — the net-of-tax cost is what the money really costs. Use the return on borrowing calculator.
Step 3 — compare return against cost
If the return comfortably exceeds the net cost, the borrowing pays for itself and builds value. If it is close, or below, the debt erodes value — do not borrow just because you can.
Step 4 — check affordability and headroom
Even a profitable use must be affordable month to month. Confirm your interest cover holds, including under a rate-rise stress test.
Step 5 — decide with a margin of safety
Require the return to beat the cost by a clear margin, not a whisker, to allow for things going less well than planned.
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Frequently asked questions
What return do I need to justify borrowing?
Comfortably more than the net-of-tax cost of the loan, with a margin of safety. If the return only just beats the cost, the risk usually is not worth it.
Why use the net-of-tax cost?
Because interest is normally tax-deductible, the real cost to your company is lower than the headline rate. Comparing against the net cost is the fair test.
What if I cannot estimate the return?
Then be cautious. Borrowing for a return you cannot articulate is a warning sign. Fund it from reserves, or wait until the case is clearer.
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