Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Interest Expense

What it is:

Interest expense is the cost of money. Interest expense is recorded on the income statement.

How it works (Example):

Let's assume you need $500,000 to buy a house. The "price" of borrowing that money is interest, and it is expressed as a percentage of the amount of money you obtain. The borrower pays the interest to the lender, and those interest payments are the borrower's interest expense. The rate of interest reflects the time value of money, the borrower's credit risk, inflation rates, and a variety of other market conditions.

Interest can be fixed or variable, meaning that the rate either stays the same through or changes according to a predetermined formula. That means interest expense often changes over time.

In banking relationships, when a person deposits money in a savings account or certificate of deposit, the person is acting as a lender to the bank and thus receives interest from the bank. In this case, it is the bank that incurs the interest expense.

From an accounting perspective, it is important to remember that interest expense isn't always the exact amount of money physically paid to a borrower in the accounting period. For example, if Company XYZ borrows money from Bank ABC and makes quarterly interest payments, Company XYZ might only be cutting a check to Bank ABC in, say, March, June, September, and December. However, the accrual method of accounting requires Company XYZ to attribute some of that interest expense to all the other months in the year so that the income statement for, say, January reflects some interest expense even though the company didn't transfer any cash to the lender in that month.

Why it Matters:

When interest expense is too high, it can wreck a company or a household. In general, high interest expense can indicate that a company is overleveraged, which is why analysts and lenders are particularly interested in measuring how much cash a company or individual brings in per month before lending.

Because a company’s failure to meet interest payments (that is, pay its interest expense) usually results in default, the interest coverage ratio is of particular interest to lenders and bondholders and acts as a margin of safety. However, because the interest coverage ratio is based on current earnings and current expenses, it primarily focuses a company’s short-term ability to meet interest obligations.

Some industries tend to have higher interest expenses than others, and cyclical companies in particular can experience significant swings in their interest expense (especially during recessions) because they may need to borrow temporarily to get through seasonal lows during the year. Thus, comparison of interest expense or any ratios involving interest expense is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.

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