Lenders don’t let borrowers access funds for free. Anytime a person or entity finances a purchase or takes out a loan, they’ll owe the lender interest on the outstanding balance.
While interest expense is largely unavoidable for growing businesses, they should still find ways to better manage and optimize this cost to improve the bottom line.
What is interest expense?
Interest expense is the cost of borrowing money. It is a type of non-operating expense that is reported on the income statement.
Both individuals and businesses can incur interest expenses when borrowing. It’s how lenders make money from letting others borrow a portion of their funds.
The amount of interest expense borrowers incur during a given period depends on a wide range of factors, including the borrowed amount, the interest rate, and the repayment term, which we’ll cover in further detail below.
Types of expenses included in interest expense
The line item for interest expense on the profit and loss statement will encompass interest paid on any borrowed funds, including:
- Bank loans
- Notes payable
- Mortgages
- Bonds
- Lines of credit
How to calculate business interest expense
Formula for calculating interest expense
The formula for calculating simple interest is pretty straightforward.
Be aware that if the loan outstanding incurs compounding interest, the calculation will be much more involved, and most would choose to use a spreadsheet or financial calculator to determine the monthly payment amount rather than doing so by hand.
To find the total amount of interest expense that will be paid on a loan, you’ll take the outstanding loan amount multiplied by the interest rate and the lifetime of the loan repayment period, typically in years.
This formula is as follows:
Factors affecting interest expense calculation
As illustrated in the formula above, there are a few key factors that influence the amount of interest a borrower pays in a given period.
Namely, this depends on the interest rate the lender charges, which is further influenced by the current Federal funds rate and the borrower’s credit, among other factors. This can vary widely depending on the lender and the nature of the loan.
Interest expense is also dependent on the principal amount of the debt, or how much the person or business borrowed. In general, the larger the debt, the greater the interest expense.
Example of interest expense calculation
To see how to calculate business interest expense in a real-life scenario, let’s consider a small manufacturing company, XYZ Factory.
The company takes out a 5-year loan of $150,000 to purchase new equipment. The loan has annual interest of 8% and a monthly repayment schedule, meaning the company will make 60 total payments.
To determine the total interest expense XYZ Factory will pay on this loan, it will make the following calculations:
Total interest expense = $150,000 * 0.08 * 5
= $60,000
Thus, the company will pay a total of $60,000 in interest over the life of the loan.
But, if they want to determine how much interest to report on the income statement for just one quarter, they can first find the monthly interest expense amount:
Monthly interest expense = $60,000 / 60 months
= $1,000
Then, multiplying this value by three, they’ll find the total interest expense for the quarter:
Quarterly interest expense = $1,000 * 3
= $3,000
Interest expense vs. interest payable
Those unfamiliar with accrual accounting practices might be unsure of the difference between interest expense and interest payable.
Interest expense represents the total amount of interest the company owes during the period, which is reported on the income statement.
On the other hand, interest payable is the total amount of interest the business has accrued during a given period, but not yet paid. It’s recorded as a liability on the balance sheet.
Impact of interest expense on business performance
Though interest is a typical expense that businesses will face as they finance an asset purchase, it does impact the bottom line.
Thus, business leaders should know how to monitor and analyze interest expense to clearly understand how it impacts overall performance.
Understanding the interest coverage ratio
One way businesses might assess the impact of interest on their financial standing is with the interest coverage ratio.
This is a metric that shows the relationship between a company’s operating income and its interest expense.
Here is the formula for the interest coverage ratio (ICR):
Interpreting the interest coverage ratio
The ICR provides insights into how easily a company can pay for its interest expense.
In other words, it shows how many times the business can “cover” interest payments for the period using its earnings.
All things being equal, the higher the ICR, the more easily it will be for a company to meet this obligation. It might indicate financial stability, meaning the company will be able to cover interest payments and make good on its obligations, even amid fluctuations in performance.
Effect of interest expense on profitability
Just like any other type of expense, interest expense can weigh on a company’s profitability, particularly if it has a large amount of outstanding debt.
Reported on the income statement, interest expense directly reduces net income. Thus, any time a company looks like improve profitability, the team should not overlook the impact of interest expense and find ways to optimize this cost where possible.
Strategies to reduce interest expense
Companies with debts outstanding likely won’t be able to get rid of interest expense altogether. However, there are some strategies they can adopt to help minimize the total amount they pay each period, such as:
- Debt consolidation: Businesses with multiple loans outstanding should look into consolidating the debt into one loan at a lower interest rate, potential resulting in lower monthly payments
- Refinancing: If the company’s financial health has changed, it may be able to re-negotiate terms with lenders to secure a lower interest rate
- Early repayment: If the lender does not charge a penalty, the business may make extra principal repayments to pay off the loan early and minimize the amount spent on interest
Interest expense best practices
Businesses must effectively manage interest expenses to ensure accurate financial reporting and enhance profitability. Here are some best practices to adopt:
Ensure accurate recording of interest expense
Properly tracking and recording interest expense provides businesses with a clear picture of their profitability, and how much they’re spending to service outstanding debts. It also ensures companies adhere to accounting standards.
As a reminder, under accrual accounting, businesses must record interest expense as it’s incurred, even if they have yet to pay it during the current reporting period.
Regularly review loan terms
As mentioned above, there are ways for businesses to reduce interest expense. Re-assessing loans outstanding and repayment terms should be a regular practice for organizations.
This way, teams can identify where they might be able to re-negotiate terms or speed up repayments to lower total interest costs.
Even if the team doesn’t make any strategic changes, it’s still important to have a clear understanding of how much the company still owes on outstanding debt to inform future purchasing decisions.
Use financial tools
Calculating and tracking interest expense by hand can get tedious, especially for debts with compounding interest, like credit cards.
Companies can implement automated accounting and financial tools to help streamline this process. There are many solutions available today that will help teams manage loan schedules and automate interest calculations and payments, giving them more time for more strategic work.
Plus, automated solutions help reduce the risk of human error, leading to more accurate financial reporting and interest payments.
Streamline accounts payable with BILL
While companies must effectively manage long-term liabilities to optimize interest payments and support profitable growth, managing short-term liabilities is also critical to success.
Automated accounts payable systems, like BILL, help businesses manage outstanding payments owed to vendors and suppliers.
BILL makes it easy to upload invoices to the platform, route the proper approvals, and schedule on-time payments. With BILL, you don’t have to worry that any payments will slip through the cracks, helping you avoid late payment fees and awkward conversations with vendors.
Sign up today to see how the platform can help streamline your accounts payable processes.
