Rising interest rates are all over the news these days. The Federal Reserve (which adjusts our nation’s interest rate as a way of slowing inflation and keeping prices stable) has increased interest rates 4 times in 2023.
If your business has borrowed money, knowing how to calculate the interest expense is important. Too often, small business owners make the mistake of only thinking about repaying the principal on their loans. But you can’t afford to forget about the interest too.
In this post, we’ll help you better understand what interest expense is all about, where to find it on your financial reports, and how to calculate it accurately so you’re never caught by surprise.
What is Interest?
The old adage in business says, “It takes money to make money.” Most small business owners understand that intuitively. However, many forget about the similar idea that it costs money to borrow money.
The price you pay to borrow someone else’s money is known as interest. Whenever someone else (a bank or even a personal friend) loans your business money with the promise that you’ll repay it within a certain amount of time, they’re taking on a risk. What if you spend their money building up your business, but your idea fails and you lose it all?
They also lose the chance to use that money themselves once it leaves their account and is deposited into yours. That “opportunity cost” is an expense to them that they want to be paid for.
Additionally, many people (like banks) are in the business of loaning money. The interest you pay on that loan is how they bring in their revenue.
What Is Interest Expense On An Income Statement?
In accounting, interest expense is the total amount of money that a business accrues on interest related to loans it has taken out.
A typical business might have multiple open loans at any given time. The money borrowed may be to purchase property or equipment, expand production, add inventory, pay bills, or meet payroll. Whenever you borrow funds (for whatever reason), the lender expects to be paid a little extra for the trouble of loaning you their money. The total of all of your interest payments in a given period is your interest expense.
Interest expense is an important thing to keep an eye on as it can accumulate quickly and change without warning if you have a variable interest rate. Whenever interest rates go up, the money you borrowed gets more expensive the longer it remains unpaid
Investopedia points out an important thing to keep in mind: “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.” (emphasis added)
Interest expense is a non-operating expense that is recorded as an expense on your company’s income statement.
Where Is Interest Expense Listed On The Income Statement?
On your income statement, there is a section labeled “operating expenses.” On some statements, it might just be called “expenses.” It depends on the accounting method you are using.
If you are new to business and the accounting that goes with it, we did a post a couple of years ago on “What Is An Income Statement?” We recommend taking a look at that and a related post on the 3 most important types of financial statements your business needs to help you get up to speed.
When it comes to interest expense, though, it is recorded as a debit against your interest expense account and a credit to your cash (or loans payable) account. This is usually done at the end of your accounting period, which normally happens at the end of each month.
By debiting the interest account, you increase your company’s expenses, and by crediting cash or loans payable you decrease your company’s assets. Recording this on a regular basis will help you stay on top of your expenses and give you a much more accurate picture of your company’s overall financial health.
(For further reading, take a look at an article The Balance Money did on “Interest and Expense on the Income Statement”… specifically how it affects companies that generate a significant part of their revenue from interest.)
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How to Calculate Interest Expense On An Income Statement
How to calculate your interest expense on an income statement doesn’t have to be complicated. You can do it in 4 simple steps:
- Find out the amount of outstanding principal on the loan during the period you’re recording.
- Look at the interest rate that is on your loan documentation.
- Determine the time period you are wanting to calculate the interest expense for.
- Use the following formula to calculate your interest expense:
Principle x Interest Rate x Time = Interest Expense
You may see it written in some places as I=Prt. The process is the same either way.
For example, if you borrowed $10,000 at 6% interest over 3 years, and don’t pay back any principal as you go, the total interest expense would be $1800.
If you wanted to know the interest expense accrued over the last 3 months, though, (assuming there has been no reduction in principle in our example) your calculation would look something like this: $10,000 x .06 x .25 = $150.
Don’t Let Interest Expense Calculation Stress You
We get it! Interest expense on an income statement isn’t your top priority, and it can be confusing. But there’s no need to let it stress you out. We can help.
Schedule a call with one of our accounting pros today! We’ve got experts in 7 locations with 40+ years of experience ready to deliver accounting peace of mind.
PS – While you’re at it, be sure to download our free tax calendar to help you stay on top of things even better!