Interest Expense

Interest incurred when company finances through debt

Interest Expense

Interest expense is one of the core expenses found in the income statement. A company must finance its assets either through debt or equity. With the former, the company will necessarily incur an expense related to the cost of borrowing. Understanding a company’s interest expense is a great way to understand its capital structure and financial performance.

Interest is often found as a separate line item below EBIT. Alternatively, some companies may list interest in the SG&A section, depending on their accounting practices.

Most commonly, interest expense arises out of company borrowing money. However, another transaction that generates interest expense is the use of capital leases. When a firm leases an asset from another company, the lease balance generates an interest expense that appears on the income statement.

 

Where does the expense appear on the income statement?

Below is an example of where interest expense appears on the income statement:

interest expense example on an income statement

Interest is found in the income statement, but can also be calculated through the debt schedule. The schedule should outline all the major pieces of debt a company has on its balance sheet, and the balances on each period opening.

This balance is multiplied by the interest rate to find the expense. Capital leases are not typically found in the debt schedule.

 

Interest Expense formula

Here is the formula to calculate interest on the income statement:

Interest Expense = Average Balance of Debt Obligation x Interest Rate

 

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EBIT and EBT

Interest is deducted from Earnings Before Interest and Taxes (EBIT) to find Earnings Before Tax (EBT).

EBIT is also known as operating income, while EBT is also known as pre-tax income.

Interest, thus, is the last deduction before taxes are deducted to arrive at net income.

 

Income tax deductibility

Interest is a tax-deductible item on the income statement and thus there is a tax saving, referred to as the tax shield.

For example:

If a company has zero debt and EBT of $1 million (with a tax rate of 30%), their taxes payable will be $300,000.

If the same company takes on debt and has an interest cost of $500,000 their new EBT will be $500,000 (with a tax rate of 30%), their taxes payable will now be only $150,000.

 

More resources

We hope this has been a helpful guide. To keep learning and developing your accounting skills we highly recommend these additional resources, in addition to our library of free finance and accounting courses offered online.