Interest Expense

AAA

DEFINITION of 'Interest Expense'

The cost incurred by an entity for borrowed funds. Interest expense is a non-operating expense shown on the income statement. It represents interest payable on any type of borrowings – bonds, loans, convertible debt or lines of credit. It is basically calculated as the interest rate times the outstanding principal amount of the debt. Interest expense on the income statement represents interest accrued during the period covered by the financial statements, and not the amount of interest actually paid over that period. While interest expense is tax-deductible for companies, in an individual's case, it depends on his or her jurisdiction and also on the loan's purpose.

INVESTOPEDIA EXPLAINS 'Interest Expense'

For most people, mortgage interest is the single-biggest category of interest expense over their lifetimes. While mortgage interest is tax-deductible in the United States, it is not tax-deductible in Canada. The loan's purpose is also critical in determining tax-deductibility of interest expense. For example, if a loan is used for bona fide investment purposes, most jurisdictions would allow the interest expense for this loan to be deducted from taxes. However, there are restrictions even on such tax-deductibility. In Canada, for instance, if the loan is taken out for an investment that is held in a registered account – such as an RRSP, RESP or Tax-Free Savings Account – interest expense is not permitted to be tax-deductible.

Interest expense often appears as a line item on a company’s balance sheet, since there are usually differences in timing between interest accrued and interest paid. If interest has been accrued but has not yet been paid, it would appear in the “Current Liabilities” section of the balance sheet. Conversely, if interest has been paid in advance, it would appear in the “Current Assets” section as a prepaid item.

The amount of interest expense for companies that have debt depends on the broad level of interest rates in the economy. Interest expense will be on the higher side during periods of rampant inflation, since most companies will have incurred debt that carries a higher interest rate. On the other hand, during periods of muted inflation, interest expense will be on the lower side.

The amount of interest expense has a direct bearing on profitability, especially for companies with a huge debt load. Heavily indebted companies may have a hard time serving their debt loads during economic downturns. At such times, investors and analysts pay particularly close attention to solvency ratios such as debt to equity and interest coverage.

The interest coverage ratio is defined as the ratio of a company’s operating income (or EBIT – earnings before interest or taxes) to its interest expense. The ratio measures a company’s ability to meet the interest expense on its debt with its operating income. A higher ratio indicates that a company has better capacity to cover its interest expense. For example, a company with $100 million in debt at 8% interest has $8 million in annual interest expense. If annual EBIT is $16 million, then its interest coverage ratio is 2. Conversely, if EBIT falls below $8 million, the interest coverage ratio of less than 1 signals that the company may have a hard time staying solvent.
 

RELATED TERMS
  1. Accrued Interest Adjustment

    The extra amount of interest that is paid to the owner of a convertible ...
  2. Capitalized Cost

    An expense that is added to the cost basis of a fixed asset on ...
  3. Expense

    1. The economic costs that a business incurs through its operations ...
  4. Creditor

    An entity (person or institution) that extends credit by giving ...
  5. Interest

    1. The charge for the privilege of borrowing money, typically ...
  6. Interest Rate

    The amount charged, expressed as a percentage of principal, by ...
Related Articles
  1. Calculating The Mortgage Interest Tax ...
    Home & Auto

    Calculating The Mortgage Interest Tax ...

  2. How Banks Set Interest Rates On Your ...
    Investing Basics

    How Banks Set Interest Rates On Your ...

  3. Interesting Facts About Imports And ...
    Economics

    Interesting Facts About Imports And ...

  4. How Interest Rates Affect Property Values
    Personal Finance

    How Interest Rates Affect Property Values

comments powered by Disqus
Hot Definitions
  1. Odious Debt

    Money borrowed by one country from another country and then misappropriated by national rulers. A nation's debt becomes odious ...
  2. Takeover

    A corporate action where an acquiring company makes a bid for an acquiree. If the target company is publicly traded, the ...
  3. Harvest Strategy

    A strategy in which investment in a particular line of business is reduced or eliminated because the revenue brought in by ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Pareto Principle

    A principle, named after economist Vilfredo Pareto, that specifies an unequal relationship between inputs and outputs. The ...
  6. Pareto Principle

    A principle, named after economist Vilfredo Pareto, that specifies an unequal relationship between inputs and outputs. The ...
Trading Center