Updated July 12, 2023
What is Interest Expense?
The term “interest expense” (IE) refers to the non-operating expense in the income statement that represents the total cost of borrowings payable for a given period. IE denotes the interest obligation accrued on borrowings (such as loans, bonds, or lines of credit) availed during the period. Still, it doesn’t mean that the amount of the interest has been paid during that period.
Explanation of Interest Expense
The IE is the aggregate of the cost of borrowing funds from banks, investors, and various other sources. The reasons for borrowing primarily include short-term working capital requirements, major capital expenditure, mergers & acquisitions, etc. Although IE primarily includes interest payable arising out of borrowings, it also comprises lease expenses, similar to IE.
The Formula for Interest Expense
The formula for simple IE can derive using outstanding debt balance, annualized interest, and no. of years. Mathematically, it represents as,
where,
- P = Outstanding debt balance
- t = No. of years
- i = Annualized interest rate
The formula for compound IE can be derived using outstanding debt balance, annualized interest, no. of years, and no. of compounding periods in a year. Mathematically, it is represented as,
where,
- P = Outstanding debt balance
- t = No. of years
- n = No. of compounding in a year
- i = Annualized interest rate
How Does Interest Expense Work?
Since IE represents interest accrued and not paid during a given period, it also appears as a line item in the balance sheet. This happens because often there are time lags between the time interest expense are recognized in the income statement on an accrual basis and the actual interest paid. Interest expense that has accrued but not yet been paid appears in the current liabilities section in the balance sheet. In contrast, interest expenses paid well in advance will be recorded as prepaid items and appear in the current assets.
Examples of Interest Expenses
Following are the examples of IE :
Example #1
Let us take a company’s example and illustrate the IE computation. The company recently borrowed $15 million from a bank for a short period of 8 months, after which it will be repaid in one bullet payment. Determine the IE borne by the company for the period if it is to be calculated at a simple interest rate of 10%.
- Given, Outstanding debt, P = $15,000,000
- Interest rate, i = 10%
- No. of years, t = 8/12 year = 0.67 year
IE can calculate using the formula given below:
Simple Interest Expense = P * t * i
- = $15,000,000 * 0.67 * 10%
- = $1,000,000
Therefore, the IE accrued for the period is $1,000,000.
Example #2
Let us take another example to explain how IE can vary due to compounding frequency. Let us assume outstanding debt of$1 million across the period of 1 year at an interest rate of 10%. Determine the interest expense if the compounding is done:
- Daily
- Monthly
- Quarterly
- Half-yearly
- Annual
Solution:
Given, Outstanding debt, P = $1,000,000
Annualized interest rate, i = 10%
No. of years, t = 1 year
1. In the case of daily compounding, n = 365.
Now, the IE can calculate using the compound interest method,
Compound Interest Expense = P * [(1 + i/n)t*n – 1]
- = $1,000,000 * [(1 + 10%/365)1*365 – 1]
- = $105,155.78
2. In case of monthly compounding n = 12
Now, the IE can calculate using the compound interest method,
Compound Interest Expense = P * [(1 + i/n)t*n – 1]
- = $1,000,000 * [(1 + 10%/12)1*12 – 1]
- = $104,713.07
3. In the case of quarterly compounding, n = 4
Now, the IE can calculate using the compound interest method,
Compound Interest Expense = P * [(1 + i/n)t*n – 1]
- = $1,000,000 * [(1 + 10%/4)1*4 – 1]
- = $103,812.89
4. In case of half-yearly compounding n = 2
Now, the IE can calculate using the compound interest method,
Compound Interest Expense = P * [(1 + i/n)t*n – 1]
- = $1,000,000 * [(1 + 10%/2)1*2 – 1]
- = $102,500.00
5. In the case of annual compounding, n = 1
Now, the IE can calculate using the compound interest method,
Compound IE = P * [(1 + i/n)t*n – 1]
- = $1,000,000 * [(1 + 10%/1)1*1 – 1]
- = $100,000.00
In this example, we can see that the IE incurred increases with the compounding frequency in the compound interest method.
How to Find the Interest Expense?
From the income statement, the IE can also be calculated as the difference between the operating profit or EBIT (Earnings Before Interest and Taxes) and the pre-tax profit or EBT (Earnings Before Tax).
Besides the income statement, IE can also calculate on the basis of the debt schedule, given that it captures all the major information pertaining to the debt on the company’s balance sheet. The interest expense can be calculated as the product of the average debt balance for the period and the effective interest rate.
What Causes Interest Expenses to Increase
The IE of a company can increase in either of the two cases:
- If the debt balance increases, which can attribute to a new loan or a higher drawdown of the available limit.
- If the interest rate increases due to deterioration in the credit profile.
Income Statement
Usually, companies capture IE as a separate line item after EBIT. However, some companies also put in under SG&A expenses (Selling, General, and Administrative)based on their accounting practices.
Also, common practice is to report IE as a separate line item. However, there are instances where companies combine it with interest income and report Net Interest Expenses.
Conclusion
So, it can be seen that IE is a very important line item in a financial statement as it captures the borrowing cost incurred by a company. Further, it can also be used to derive various metrics (such as interest coverage ratio) to indicate a company’s credit.
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This is a guide to Interest Expenses. Here we also discuss the introduction and how interest expense works. Along with examples. You may also have a look at the following articles to learn more –
