Interest Expense

Interest expense is the cost a business incurs for the use of borrowed money during an accounting period. It covers interest on bank loans, lines of credit, bonds, notes payable, finance leases and other forms of debt, and it is recognized as it accrues over time, whether or not it has been paid. Interest expense is reported on the income statement, usually below operating income as a non-operating or financing cost, which is why measures such as EBIT and operating income are calculated before it.

The size of a company's interest expense depends on how much it has borrowed, the interest rates it pays and whether those rates are fixed or variable. A company funded mainly with debt will have a much larger interest expense than one funded mainly with equity, and its profits will be more sensitive to changes in interest rates.

For a simple loan, interest for a period is the principal multiplied by the annual rate and by the fraction of the year. A company that borrows $500,000 at 7 percent on 1 September, with interest payable every six months, incurs about $2,917 of interest each month. At its 31 December year end, four months have passed, so it records interest expense of about $11,667 by debiting interest expense and crediting interest payable, even though no cash has yet been paid. When it pays $17,500 on 1 March, it clears the payable and records the two months of the new year as expense.

For bonds and other debt issued at a discount or premium, interest expense is measured using the effective interest method rather than the cash coupon. Interest expense equals the carrying amount of the debt multiplied by the market rate at issue. If a company issues $1,000,000 of five-year bonds payable with a 5 percent coupon for $957,876, giving a market yield of 6 percent, first-year interest expense is about $57,473, while the cash coupon is $50,000. The difference, about $7,473, is amortization of bond discount, which increases the carrying amount each year. Issue costs are also amortized into interest expense over the life of the debt.

Not all interest goes straight to expense. Under US GAAP (ASC 835-20) and IAS 23, interest incurred while constructing a qualifying asset, such as a building, ship or power plant that takes a substantial period to get ready for use, is capitalized as part of the asset's cost. It is then expensed gradually through depreciation once the asset is in service. Companies disclose both the interest incurred and the amount capitalized, so analysts can see the full cost of borrowing.

Lenders and analysts use interest expense to judge whether a company can comfortably carry its debt. The interest coverage ratio, also called times interest earned, divides EBIT by interest expense. A company with EBIT of $12 million and interest expense of $3 million has coverage of 4 times; a ratio falling toward 1.5 or below is generally viewed as a warning sign. Loan agreements often include minimum coverage covenants. Rising interest rates since 2022 have increased interest expense sharply for companies with floating-rate debt, highlighting the risk of relying on short-term or variable borrowing.

Interest expense is generally tax-deductible, which lowers the true cost of borrowing; the effective rate is measured by the after-tax cost of debt. In the United States, however, section 163(j) of the Internal Revenue Code limits the deduction for business interest, broadly to 30 percent of adjusted taxable income plus business interest income, with an exemption for smaller businesses below a gross receipts threshold. Disallowed interest can be carried forward to later years. Many other countries have similar limits, following the OECD's recommendations against base erosion through excessive interest deductions. On the cash flow statement under US GAAP, interest paid is classified as an operating cash flow and must be disclosed. Related items include the bond interest expense line used by issuers of bonds.