What Is an Interest Expense?An interest expense is the cost incurred by an entity for borrowed funds. Interest expense is a non-operating expense shown on the income statement. It represents interest payable on any borrowings—bonds, loans, convertible debt or lines of credit. It is essentially calculated as the interest rate times the outstanding principal amount of the debt. Interest expense on the income statement represents interest accrued during the period covered by the financial statements, and not the amount of interest paid over that period. While interest expense is tax-deductible for companies, in an individual's case, it depends on their jurisdiction and also on the loan's purpose. Show
For most people, mortgage interest is the single-biggest category of interest expense over their lifetimes as interest can total tens of thousands of dollars over the life of a mortgage as illustrated by online calculators. Interest ExpenseHow Interest Expenses WorkInterest expense often appears as a line item on a company’s balance sheet, since there are usually differences in timing between interest accrued and interest paid. If interest has been accrued but has not yet been paid, it would appear in the “current liabilities” section of the balance sheet. Conversely, if interest has been paid in advance, it would appear in the “current assets” section as a prepaid item. While mortgage interest is tax-deductible in the United States, it is not tax-deductible in Canada. The loan's purpose is also critical in determining tax-deductibility of interest expense. For example, if a loan is used for bona fide investment purposes, most jurisdictions would allow the interest expense for this loan to be deducted from taxes. However, there are restrictions even on such tax-deductibility. In Canada, for instance, if the loan is taken out for an investment that is held in a registered account—such as a Registered Retirement Savings Plan (RRSP), Registered Education Savings Plan (RESP) or Tax-Free Savings Account—interest expense is not permitted to be tax-deductible. The amount of interest expense for companies that have debt depends on the broad level of interest rates in the economy. Interest expense will be on the higher side during periods of rampant inflation since most companies will have incurred debt that carries a higher interest rate. On the other hand, during periods of muted inflation, interest expense will be on the lower side. The amount of interest expense has a direct bearing on profitability, especially for companies with a huge debt load. Heavily indebted companies may have a hard time serving their debt loads during economic downturns. At such times, investors and analysts pay particularly close attention to solvency ratios such as debt to equity and interest coverage. Key Takeaways
Interest Coverage RatioThe interest coverage ratio is defined as the ratio of a company’s operating income (or EBIT—earnings before interest or taxes) to its interest expense. The ratio measures a company’s ability to meet the interest expense on its debt with its operating income. A higher ratio indicates that a company has a better capacity to cover its interest expense. For example, a company with $100 million in debt at 8% interest has $8 million in annual interest expense. If annual EBIT is $80 million, then its interest coverage ratio is 10, which shows that the company can comfortably meet its obligations to pay interest. Conversely, if EBIT falls below $24 million, the interest coverage ratio of less than 3 signals that the company may have a hard time staying solvent as an interest coverage of less than 3 times is often seen as a "red flag." Now, it’s time to move on to the second metric which can be used to derive the free cash flow to the firm (FCFF). This metric is the cash flow from operations. These types of questions involve a complete cash flow statement being provided as the question and expect the student to derive free cash flow to the firm (FCFF) as an output. The conceptual understanding that we built in the previous article regarding the difference between these two closely related terms will come in handy here. The Difference Is Net Cash Flow towards Long Term Investments:We already know that the difference between free cash flow to the firm (FCFF) and cash flow from operations arises because we consider long term investments as being the part of one whereas we do not consider for the other. Therefore, simply put, free cash flow to the firm (FCFF) can be derived from cash flow from operations in the following manner: Free Cash Flow to the Firm (FCFF) = Cash flow from Operations – Net Investment in Long Term Assets However, this is only an approximation. To consider this to be the accurate derivation of free cash flow to the firm (FCFF) would be an oversimplification. The Complication: Interest Expense:There is another complication that is introduced because of the way we treat interest expense while preparing statement of cash flows. We consider interest expense as a financing expense. That is because, the operating cash flows of the firm would remain the exact same regardless of whether we ran the business on own money or on borrowed money. Hence, we subtract them from operating cash flow and send them to financing cash flows. Well, when calculating free cash flow to the firm (FCFF) the perspective changes. We are not concerned whether the money is spent because of regular operations or not. All we are concerned about is that it reduces the money available for the investors. Hence, we must add this interest expense back our above formula. Thus we arrive at a modified formula which is FCFF = Cash flow from Operations – Net Investment in Long Term Assets + Interest Expense However, adding back the entire interest expense would also be an oversimplification. Thus, we have one last adjustment to make before we can arrive at the free cash flow to the firm (FCFF) number. That adjustment pertains to tax. Since we have already deducted tax, the interest expenditure should be reduced to account for its effect. Thus the final formula is: FCFF = Cash flow from Operations – Net Investment in Long Term Assets + Interest Expense (1-Tax Rate) The above two formulas were only intermediate calculations to derive the final formula and must not be used. The third formula (highlighted with border) is the final formula which must be used to derive the free cash flow to the firm in case all the inputs are known. Example: Let’s understand this with the help of an example: Cash flow from operations = $1000 Cash Outflow (New Machine) = $250 Cash Inflow (Sale of Old Machine) = $75 Interest Expense = $100 Tax Rate = 40% Calculation #1: Net Cash Flow towards Long Term Assets = $250 - $75 = $175 Calculation #2: After Tax Interest Expense = $100*(1 – 0.40) = $60 Therefore, FCFF = Cash flow from Operations – Net Investment in Long Term Assets + Interest Expense (1-Tax Rate) FCFF = $1000 – $175 + $60 =$885 Needless to say this is an over simplified version for explanation. The questions on the exam will be much more detailed and calculation intensive. However, the logic and the steps required to solve them remain the same. Source of Confusion:Many students find it confusing that interest is the only financing expense that is added back to cash flow from operations. They wonder why other expenses like dividends and share repurchases do not affect the free cash flow to the firm. The answer lies in the sequence in which the calculation happens. Interest expense was earlier subtracted to arrive at the net income. Hence, it needs to be added back. Other expenses like dividends and share repurchase are not subtracted to arrive at the net income and hence no adjustments need to be made for them! Authorship/Referencing - About the Author(s)
Is interest expense added back to cash flow from operations?Many students find it confusing that interest is the only financing expense that is added back to cash flow from operations. They wonder why other expenses like dividends and share repurchases do not affect the free cash flow to the firm.
How is interest expense treated in cash flow?interest paid and interest received should be treated as Cash Flows from Operating Activities. flows from interest paid should be treated as Cash Flows from Financing Activities while interest received should be treated as Cash Flows from Investing Activities.
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Why is interest expense added back to cash flow
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