Interest Expense

What it is

Interest expense is the cost a borrower pays to use someone else’s money. For businesses, it represents interest accrued on debt instruments—bonds, bank loans, convertible debt, lines of credit—and is reported on the income statement as a non-operating expense. It is generally calculated as the interest rate multiplied by the outstanding principal.

How it works in accounting

• On the income statement: interest expense reflects interest accrued during the reporting period, not necessarily the cash paid in that period.
• On the balance sheet:
• Accrued but unpaid interest appears as a current liability (interest payable).
• Interest paid in advance is recorded as a current asset (prepaid interest).
• For tax purposes: interest expense is commonly tax-deductible for corporations. For individuals, deductibility depends on jurisdiction and the loan’s purpose (for example, mortgage interest is often deductible in some countries but not in others).

Tax considerations

• Corporations typically receive favorable tax treatment for interest expense (deductible).
• For individuals, treatment varies by country and use of funds. For example:
• Mortgage interest is a common deductible item in some jurisdictions.
• Interest on loans used for bona fide investment purposes is often deductible.
• Some jurisdictions disallow deductions when the investment is held in certain registered accounts.

Drivers of interest expense

The total interest expense a company pays depends on:
* The amount of outstanding debt.
* The interest rates attached to that debt—higher in periods of elevated inflation and lower when inflation and rates are muted.
Changes in interest expense directly affect profitability, especially for highly leveraged companies.

Effect on financial health

Large interest expenses can strain profitability and cash flow. During economic downturns, heavily indebted companies may struggle to service debt. Analysts and investors monitor solvency and coverage ratios (e.g., debt-to-equity, interest coverage ratio) to evaluate a company’s ability to manage its debt.

Interest coverage ratio

The interest coverage ratio measures a company’s ability to meet interest payments from operating earnings.

Formula:
Interest coverage ratio = EBIT ÷ Interest expense

Interpretation:
* A higher ratio indicates greater capacity to cover interest costs.
* Ratios below about 3 are often considered a warning sign that a company may have difficulty meeting interest obligations.

Example:
* Debt: $100 million at 8% → annual interest expense = $8 million.
* EBIT: $80 million → interest coverage ratio = $80 million ÷ $8 million = 10.
A ratio of 10 indicates the company can comfortably cover its interest expenses. If EBIT fell below $24 million, the ratio would drop below 3 and signal increased risk.

Key takeaways

• Interest expense is the recorded cost of borrowing and is reflected on the income statement as interest accrues.
• It affects profitability and cash flow—particularly for firms with large debt loads.
• Tax treatment varies by entity type and jurisdiction; corporations commonly deduct interest expense.
• The interest coverage ratio is a primary metric to assess a company’s ability to service its debt; low values can indicate solvency risk.