Interest Expense: Definition, Formula, Types, and Impact!

If you have borrowed funds, which can be business loans, credit cards, or bonds. You need to pay interest on the money borrowed, and this is known as interest expense. It plays a crucial role in identifying a company's profits, financial health/status, as well as tax obligations.

Having a complete knowledge of the interest expense helps businesses manage debts seamlessly, predict cash flows, and encourage strategic decisions. In this blog, we will understand everything in detail. Let’s scroll down. 

What is Interest Expense? 

Interest Expense is found in the income statements and is referred to an expense type that incurs the cost of borrowing funds. It is often listed below EBIT (Earnings Before Interest and Taxes). Also, some businesses might be listed in the SG&A sections based on their accounting practices.

Please note: Interest Expense comes into play when a company borrows money. However, capital leases also incur these expenses when a company gets assets on lease from another business. The cost of lease balance is displayed on the income statement, which is called interest expense. 

What are the Types of Interest Expense? 

Interest Expense on Profit and Loss Statements is applied on the below types of funds borrowed: 

• Loans taken from banks 
• Notes payables 
• Mortgages 
• Bonds 
• Lines of Credit 

How to Calculate Interest Expense? 

Interest Expense = Loan Amount x Rate of Interest x Length of Time Outstanding 

Where, 

Loan Amount = Principal amount borrowed from the bank 

Rate of Interest = It’s the annual interest rate applied on the borrowed amount 

Length of Time Outstanding = The duration for which the amount is borrowed 

Example of Interest Expense Calculations

Consider a company has availed a bank loan of ₹10,00,000 with an interest rate of 12% for 6 months. Let’s calculate the interest expense below: 

Principal Amount = ₹10,00,000  

Rate of Interest = 12% 

Outstanding time = 6 months 

Interest Expense = 10,00,000 x 12 x (6/12) = ₹60,000 

Also, Check out Our Reducing Interest Rate Calculator

Which Factors Affect Interest Expense Calculations? 

1. The interest rate charged by the lender is the primary factor that might change based on federal funds and the borrower's credit. This completely depends on the nature of the loan.
2. It also depends on the loan amount borrowed by the business. For a larger loan amount, interest expense also grows. 

How Does Interest Expense Impact Business Performance? 

1. Minimized Net Profit: 

• It is considered to be a non-operating cost in the income receipt, where higher interest costs lower net profits. 
• So, even if the company performs well; it appears to be less profitable. 

2. Impact on Cash Flow 

• Interest expenses minimize cash outflow, thus delaying business operations, expansions, and debt payments. 
• High interest rates can strain your liquidity and adversely impact working capital. 

3. Poor Financial Ratios 

• Interest Coverage Ratio 

It depicts how easily a company can pay the interest. 

• Debt to Equity Ratio 

With growing interest rates, the debts are also higher, which increases financial risks.

Interest expense affects the financial ratios, which can shake the investor's trust and borrowing ability.

Read More: Miscellaneous Expenses

How Interest Expense Works? 

A business borrowing money for its operations or expansions agrees to pay the interest applied on the amount borrowed. This is considered an interest expense in the financial documents.

For every accounting period, the borrower computes interest on the loan amount using the given interest rate and the outstanding time. The result is then recorded in the income statements, which minimizes the overall profit levels.

If the interest payment is pending, it is displayed as “Interest Payable” under current liabilities until transactions are complete.

For a period, when debts are repaid or freshly borrowed, there are fluctuations in the interest expense based on the company’s borrowing pattern. 

Conclusion 

Interest Expense isn’t just a financial need- it clearly depicts how efficiently a business manages its debts. It impacts profit levels and cash flow, so understanding the term becomes crucial.

Save the blog and monitor your interest expense regularly to optimize debt repayments. Stay tuned until we publish next.

FAQs on Interest Expense 

1. Is Interest Expense an asset or liability? 

Interest expense is neither an asset nor a liability; it’s an expense that incurs the cost of borrowing on financial statements. 

2. What is the interest coverage ratio? 

Interest coverage ratio is defined as the ratio of a company's operating income to its interest expense. 

3. Which are the best practices to balance interest expense? 

• Maintaining accurate interest expense
• Regularly review the loan terms and conditions
• Use financial tools like accounting software to keep track of expenses smoothly. 

4. Which category interest expense falls under? 

Interest expense falls under non-operating expenses. 

5. How do you record interest expenses? 

Create a journal entry of debits and credits from the interest expense and loan amount respectively.

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