The definition of interest expense
An interest expense is a cost a company incurs as a result of borrowing money. The interest expense is classified as a non-operating expense and is unrelated to core operations. The interest expense is represented on the income statement and signifies interest payable on borrowings, for example, loans, lines of credit and bonds.
The interest expense shown on a company’s income statement represents the interest that has accumulated during the time period specified on the financial statements. Interest expenses are tax-deductible for companies. However, interest expenses are only tax-deductible for individuals in certain circumstances, for example, on mortgage payments.
Interest expense and your company
You will normally find interest expenses listed as a line item on your company’s balance sheet because there are differences between the time that the interest is accrued and when the interest is paid. Where your company’s interest has been accrued but it has not been paid, this entry would be listed in the current liabilities part of your balance sheet. However, if your company has paid the interest in advance, this interest expense would be listed in the current assets section of your balance sheet, as a prepaid item.
The amount of interest expense that your company will be liable for is dependent on the overall interest rate level in the economy. Your company will need to pay higher interest expenses when there is high inflation. On the other hand, your company will pay lower interest expenses if there is low inflation.
The amount of interest expenses your company accrues can affect your profitability. This is especially the case if your company has a lot of debt. Where your company has a high level of debt, it will be difficult to keep up with payments if the economy experiences a downturn. In these periods, it is recommended that you seek professional advice to examine your financial situation to determine whether your company can remain solvent. It is also recommended that you keep a downloadable ROI calculator handy so your business won’t get to the point of getting into high levels of debt.
Interest coverage ratio
The interest coverage ratio is a debt and profitability ratio that is used to work out whether your company can easily pay interest on its debt. Additionally, the interest coverage ratio is the ratio of your company’s earnings before interest or taxes (EBIT) to its interest expense. Where your company has a high interest coverage ratio, it is likely that it is in a good position to pay its interest expenses.
How to calculate your interest expense
Follow the steps below to calculate the interest expense for your company:
1. Establish the outstanding amount on the debt that was originally borrowed (principal amount) during the specified measurement period.
2. Ascertain the interest rate over a full year. This figure will be available in the documentation for your loan.
3. Apply the interest formula below to determine the interest expense.
Principal x interest rate x time period = interest expense
An example of this formula is:
Your company has taken a loan of $85,000 with a 6.5% interest rate. You need to find out the amount of the interest expense for the last three months.
The following calculation will provide you with the amount of interest expense that is accrued on your loan over three months:
$85,000 principal x .065 interest rate x .25 time period
= $1,381.25 interest expense
When you have calculated the interest expense, it should be listed as an accrued liability. This record needs to be a debit to interest expense, which is the expense account and a credit to accrued liabilities, which is the liability account. When your company receives an invoice for the interest expense, the credit should be moved to another liability account, which is the accounts payable section. After your company has paid the interest, the accounts payable section is debited and the cash account is credited to demonstrate that funds have been spent.
How to calculate interest expense on income statement
The income statement is one of your company’s main financial records that provide details about its profit and loss over a specified period of time. The profit and loss is calculated by recording all of your revenue and subtracting all expenses from non-operating and operating business activities.
Your interest expenses are one of the key expenses located on your income statement. Reviewing your income statement and your interest expense is an invaluable way of understanding your company’s financial performance and structure.
The interest expense on your income statement will typically represent the cost of borrowing from bond investors or banks to add equipment or property to the balance sheet, increase inventory, acquire competing businesses or meet other short-term business needs.
If your business is asset-intensive, an increase in interest rates can have serious implications. The best way to guard against potential issues is to attempt to keep the interest at the same rate for as long as possible. This will ensure that your company can keep making the lowest payments in relation to its interest rates.
Some companies choose to report interest expense and interest income as distinct line items on their income statement. Other companies mix these two figures and report them under ‘interest income – net’ or ‘interest expense – net.’ This reporting depends on whether there is more interest income than interest expense. Net is used on the income statement in this situation to show that the person doing the accounts has taken away interest income from interest expense to come up with a figure.
For example, if your company has paid $30 in interest on its debt and has earned $10 from its savings account, the income statement will show interest expense – net of $20.
In addition to using the formula above, you can also take the following steps to calculate the income-expense on an income statement:
- Work out your annual growth rate – Determine how much your company’s revenue has grown over the last three years. You should then average this figure to work out your company’s percentage growth rate.
- Determine your current working capital – Establish the amount of cash your company has on hand to pay for business expenses. Record this figure as a dollar amount.
- Include your company’s current liabilities – Find out the exact amount of money your company owes and record this figure as a dollar amount.
- Multiply your company’s growth rate times its working capital – This figure is the amount of extra capital your company will need in the upcoming year. This figure is known as your company’s projected working capital.
- Subtract your company’s liabilities from its projected working capital – The figure you arrive at is the amount that your company will need to borrow to increase its working capital in the coming year.
- Multiply the amount your company needs to burrow times the current interest rate it is paying. This figure is the amount of additional interest expense your business will incur in the upcoming year.
Although companies record their interest expense on their income statements, the interest expense can also be calculated through the debt schedule. A company’s debt schedule lists all of its debts based on maturity. Your debt schedule can be used to create a cash flow analysis for your company. The interest expense in your company’s debt schedule will flow into its income statement, the closing debt balance is represented on the balance sheet and the principal repayment is shown on the cash flow statement.
How to calculate interest expense on long-term debt
If your company needs cash, it is likely that it will get this money by securing long-term debt, for example a bank loan. The interest that accumulates on your long-term debt is regarded as a business expense for tax and financial record purposes. In order to budget your company’s money accurately, you should work out the amount of annual interest expense your company will report on its long-term borrowing.
However, to get a true picture of the amount of interest expense of your long-term loans, you will need to use the calculation that is applicable to the terms of repayment.
The following are two types of long-term borrowing and the formulas to calculate interest expense:
1. Bank loans
A bank loan is a popular form of long-term borrowing for most companies. The documentation that you sign will detail the rate of interest and also how this interest is calculated. Generally, banks compound the interest at fixed periods, for example, monthly or quarterly. Compound interest is a way of adding accrued interest to the principal balance and calculating future interest accruals on the total outstanding debt. Depending on the payments your company makes, the total outstanding debt could include the principal and the interest of the long-term loan.
The formula for working out the compound interest on your company’s long-term loan is as follows:
Total amount of principal and interest in future (or future value) less principal amount at present (or present value)
= [P (1 + i)n] – P
= P [(1 + i)n – 1]
The following is an example of compound interest from investopedia.com:
Take a three-year loan of $10,000 at an interest rate of 5% that compounds annually.
What would be the amount of interest?
In this case, it would be: $10,000 [(1 + 0.05)3 – 1] = $10,000 [1.157625 – 1] = $1,576.25.
The above example demonstrates that compound interest is also concerned with the accumulated interest of former periods. So, the interest amounts for all the three years fluctuate. Therefore, the interest that is due at the end of each year is different. However, the total interest that is owed over the three-year term of the loan is $1,576.25.
2. Simple bond interest
This type of long-term borrowing is popular with larger companies who need to raise capital. This involves issuing bonds to investors who are members of the general public. The company can vary the terms on the bonds, but it is common for simple interest to be used. Simple interest is where interest only accrues on the amount that was originally borrowed. This means that the principal balance stays the same for the duration of the bond and is repaid back to investors at the end of the term, as a lump sum. In this case, the interest is paid to investors at the time it accrues, which explains the reason why the principal amount does not change.
The formula for simple interest is as follows:
Simple Interest, I = P x R x T
P = Principal Amount
R = Interest Rate
T = # of Periods
The following example of how simple interest works is courtesy of corporatefinanceinstitute.com:
Mr. Albertson plans to place his money in a certificate of deposit that matures in three months. The principal is $10,000 and 5% interest is earned annually. He wants to calculate how much interest he will earn in those three months.
I = P x R x T
I = $10,000 x 5%/year x 3/12 of a year
I = $125
Calculating interest expense for your company is vital when working out profit and loss. The amount you pay in interest enables you to make strategic decisions in relation to different aspects of your company, for example, labor costs.
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