Businessman Investor

Touching base with the rational business psyche of stock market investors

Friday, November 28, 2014

The Cost of Borrowing and Its Impact Against Corporate Profitability

This is Part 3 of a Series. Go to Part 2: Core Business Profitability and Its Mathematical Derivation

The Corporate Cost of Borrowing. This can be observed by
focusing on the company's Financial Liabilities; those interest-
bearing debt the company has deliberately externally
sourced to finance business operations.
Wouldn't it be nice to know what interest rate the company is borrowing at and be able to observe how it is affecting overall corporate profitability? That is what we are about to do. The Effective Interest Rate can be observed by focusing on the Financial Liabilities of the company.

We qualify Financial Liabilities because these are those interest-bearing debt which the company has deliberately sourced externally to finance its operations, as opposed to Trade Liabilities which came about because of business operations (e.g. accounts payable).

Financial Liabilities can be observed under Cash Flow from Financing Activities while Trade Liabilities can be seen under Cash Flow from Operating Activities.

Effective Interest Rate is computed as follows:

Interest Expense / Financial Liabilities = Interest Rate

From a profitability-biased stand point, the company should only be borrowing money at a rate lower than what it can make from its core business operations (i.e. Core Business Profitability). Nonetheless, the effect this cost of borrowing brings against corporate profitability can only go insofar as to how much Financial Liabilities weigh against overall Operating Assets:

Financial Liabilities / Operating Assets = Financial Liabilities Weight


Core Business Profitability (i.e. EBIT/Operating Assets)


Interest Rate x Financial Liabilities Weight


(EBIT - Interest Expense)/Operating Assets

Which simply is:

EBT / Operating Assets = After Interest Business Profitability

Continue to Part 4: The Burden of Taxation and the Final Form of Corporate Profitability

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The information presented here is for educational purposes only. Under no circumstances should it be construed as a recommendation to buy, sell, or hold any stocks. If you choose to use this information, you do so at your own risk.

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