Interest Expense: Definition, Formula, and Examples
Interest expense is the cost of borrowing money from a lender. Interest expense appears on the income statement after operating income.
What is Interest Expense?
Interest expense is the cost of borrowing money from a lender. When a lender provides funds to a company, it expects to receive a payment in exchange. This payment is known as interest expense.
The two main parts of a loan are principal and interest. Principal is the amount of money borrowed, while interest is the cost of borrowing that money. The interest payment is added to the principal to arrive at the total amount due to the lender.
Interest expense appears on the income statement after operating income, as it is a non-operating expense. Interest expenses can be applied to any type of borrowing. Typically, the following items carry an interest obligation:
- Loans
- Credit Cards
- Lines of Credit
- Bonds
- Finance Leases
What is the Formula for Interest Expense?
The formula for interest expense is:
Interest Expense = Average Debt Balance x Interest Rate x Time Period
Where:
- Average Debt Balance = (Beginning Debt Balance + Ending Debt Balance) / 2
- Interest Rate = Annualized Interest Rate
- Time Period = Number of days in a given time period / number of days in a year
Example of Interest Expense
Assume ABC Company has a $10 million loan at a fixed interest rate of 8%. If ABC did not pay down its loan throughout the year and makes one payment at the end of the year, its annual interest expense will be $800,000.
Annual interest expense = $10 million x 0.08 x (365 / 365) = $800,000
Where:
- $10 million = Average debt balance
- 8% = 0.08 = Interest expense
- 365 days / 365 days = Time period
Assume instead that ABC makes payments monthly. Its fiscal year begins January 1 and runs through December 31 in a year that is not a leap year. In this case, the monthly interest expense for January would be:
Interest expense for January = $10 million x 0.08 x (31 / 365) = $67,945.21
Where:
- $10 million = Average debt balance
- 8% = 0.08 = Interest expense
- 31 days / 365 days = Time period
In February, the interest expense would be slightly lower because the principal on the loan was paid down at the end of January, and the average debt balance was, therefore, lower for the month of February. The month of February is also shorter, so the time period would be 28 / 365.
Assume, instead, that ABC Company has a two-year interest-only line of credit at a fixed interest rate of 10% that it draws on only when necessary. This impacts the average debt balance because the debt balance varies throughout the year. If ABC Company draws $50,000 on January 1 and $75,000 on July 1, its annual interest expense can be calculated as follows:
Annual interest expense = ($50,000 + $125,000 / 2) x 0.10 = $8,750
Where:
- ($50,000 beginning balance + $125,000 ending balance) / 2 = $87,500 = Average debt balance
- 10% = 0.10 = Interest expense
- 365 days / 365 days = Time period
Real Company Example: Walmart's Interest Expense
This consolidated income statement was included in Walmart’s Annual Report, Form 10-K, for the year ended January 31, 2023. In Walmart’s income statement, the company nets its interest income– interest it has earned from investors– against its interest expense– amounts it has paid to lenders. Walmart also breaks down its interest expense into debt interest expense and finance lease interest expense– which amount to $1.787 billion and $341 million in the fiscal year 2023. With $254 million in interest income for 2023, the net interest expense is $1.874 billion.
What is the Interest Coverage Ratio?
The interest coverage ratio is a measure of a company’s ability to meet its interest expense obligations with its operating income.
Interest Coverage Ratio Formula = Operating Income / Interest Expense
An interest coverage ratio of less than 3 is a negative sign, as it indicates that a company may have a hard time paying its interest expense with the current operating income. See this article to learn more about the interest coverage ratio.
For example, ABC Company has $8,000 in annual interest expense. If its operating income is $160,000, it has an interest coverage ratio of 20. This is a good indicator that the company will have no problems covering its interest expense obligations with its operating income.
Interest Coverage Ratio = $160,000 / $8,000 = 20
Where:
- $160,000 = Operating Income
- $8,000 = Interest Expense
If, on the other hand, ABC Company had only $20,000 in operating income, its interest coverage ratio would be 2.5. That would be indicative of a major issue with its ability to pay its interest expense on its debt obligations.
Interest Coverage Ratio = $20,000 / $8,000 = 2.5
Where:
- $20,000 = Operating Income
- $8,000 = Interest Expense
Is Interest Expense an Operating Expense?
Interest expense is not an operating expense. Operating expenses are related to the day-to-day operations of a business. Interest expense is a cost incurred from borrowing money from lenders. On an income statement, non-operating expenses such as interest will appear after the calculation for operating income.
When calculating a company’s income, there may be several subcategories of income that include or exclude items such as interest expense.
- Earnings Before Interest, Taxes, Depreciation, and Amortization
- Earnings Before Interest and Taxes
- Earnings Before Tax
- Net Income
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a figure that takes operating income and adds back in the costs of depreciation and amortization for the period. It is not a Generally Accepted Accounting Principles (GAAP) approved figure, and it will not appear on the income statement. It may be optionally disclosed in the notes to the financial statements.
Operating income– or earnings before interest and taxes (EBIT)– only includes sales revenue and operating expenses. It shows the profit the company derives from its core business activities. It excludes interest expense because it is not directly related to the day-to-day operations of the business.
Earnings before tax– or income before income taxes– includes all revenue and expenses except for income tax. Net income is the “bottom line” resulting figure after subtracting all expenses.
What is Compounding Interest?
Interest can be calculated in one of two ways:
- Simple interest
- Compound interest
Simple interest is a term for interest expense that is calculated only on the principal, or originating amount, of a loan. It is the most straightforward form of interest. Compound interest, on the other hand, calculates both outstanding principal and accumulated interest that has “compounded” in previous periods. It is essentially simple interest plus interest on previous interest.
Interest Terminology
Here are some of the most common interest terms.
Annual Percentage Rate (APR)
Interest expense is typically paid monthly, but it is commonly depicted as an annualized amount. Annual percentage rate (APR) is the most commonly reported interest rate. It represents the annual cost of borrowing a sum of money. APR is a standardized number that includes additional fees and costs associated with borrowing, and it can be used to compare lending options before a company goes into business with a specific lender. It does not, however, take into account compounding interest.
Annual Percentage Yield (APY)
Annual percentage yield is the rate of return paid on borrowed funds over a year, taking into account compounding interest.
Effective Annual Interest Rate (EAR)
The effective annual interest rate is the total interest a company can expect to pay out on a loan or other debt obligation after taking into account compounding interest over the year.
Nominal Interest Rate
The nominal interest rate is the interest rate stated by a lender. It does not take into account any fees or compounding interest over the time period.
Additional Resources
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