The expense of borrowing money is interest. It appears on the income statement as a non-operating expense and is derived from lending agreements such as credit lines, loans, and bonds. Debt costs less to fund than equity since interest expenses are typically tax deductible.
But, if the borrower is unable to repay the debt, an excessive quantity of debt also increases the chance of company collapse. As a result, compared to the asset base and earning potential of a corporation, a careful management team only incurs a small amount of interest expenditure.
Accounting for Interest Expense
The amount of interest owed is typically billed to the borrower by the lender. The typical accounting entry is a debit to interest expense and a credit to accounts payable when the borrower gets this invoice. In order to quickly complete its books at the end of the month even though a bill from the lender had not yet arrived, the borrower could instead accrue the cost by debiting interest expenditure and crediting interest payable or accrued interest.
In order for this journal entry to automatically reverse at the start of the following accounting period, the borrower should set it up as a reversing entry. The borrower can then record the lender's invoice when it ultimately arrives in the same way that an invoice is recorded.
The borrower must accrue the additional interest expense not shown on the lender's invoice if the dates of the accounting period do not exactly correspond to the period covered by the lender's invoice. If a lender's invoice, for instance, only extends through the 25th of the month, the borrower should be responsible for accruing the extra interest costs related to any debt that is still owed from the 26th to the last day of the month.
How to Calculate Interest Expense
The amount of interest paid is frequently stated as a percentage of the principal balance still owed. The formula for interest expenses is:
(Days during which funds were borrowed ÷ 365 Days) x Interest rate x Principal = Interest expense
Example of Interest Expense
ABC International takes out a bank loan for $1,000,000 on June 1 and pays it back on July 15.The loan carries an 8% interest rate.. The calculation of the interest expenditure for the month of June is as follows:
( 30 days ÷ 365 days ) x 8% x $1,000,000 = $6,575.34
The following formula is used to determine the interest expense for July:
( 15 days ÷ 365 days ) x 8% x $1,000,000 = $3,287.67
Interest Coverage Ratio
The operating income of a corporation, or EBIT (profits before interest or taxes), divided by the interest expense is known as the interest coverage ratio. The ratio evaluates how well a business can use its operating income to pay its debt's interest costs. An organization's ability to pay its interest costs is better demonstrated by a greater ratio.
For instance, the annual interest expense for a firm with $100 million in debt at 8% interest is $8 million. If annual EBIT is $80 million, then the company's interest coverage ratio is 10, indicating that it can comfortably satisfy its interest payment commitments. An interest coverage ratio of less than 3 is typically regarded as a "red flag," thus if EBIT drops below $24 million, it indicates that the company may have trouble remaining solvent.
An accounting item called an interest expense is incurred as a result of repaying debt.
Interest costs frequently receive a favorable tax treatment.
The potential influence on a company's profitability increases with the amount of interest expense. To delve further, coverage ratios might be used.