# Interest Expenses: How They Work, Plus Coverage Ratio Explained

> **Definition**
>
> Interest expense is the price paid to borrow money.

## What Is an Interest Expense?

A company records an interest expense when it takes out a loan from a lender. Interest expense is a [non-operating expense](https://www.investopedia.com/terms/n/non-operating-expense.asp) shown on the income statement.

More precisely, interest expense represents interest payable on any borrowings—bonds, loans, [convertible](https://www.investopedia.com/terms/c/convertibles.asp) 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.

Interest expense is tax-deductible for companies. However, in an individual's case, whether it is or not depends on their jurisdiction and also on the loan's purpose.

For most people, mortgage interest is the single-biggest category of interest expense over their lifetimes. The amount of interest can total tens of thousands of dollars over the life of a mortgage, as illustrated by [online calculators](https://www.investopedia.com/mortgage-amortization-calculator-5118201).

### Key Takeaways

*   An interest expense is an accounting item that is recorded as interest accrues on debt.
*   Interest expenses are often given favorable tax treatment.
*   For companies, the greater the interest expense the greater the potential impact on profitability. Coverage ratios can be used to dig deeper.

  

![Interest Expense](https://www.investopedia.com/thmb/w6oHHAeTRCT4btHrWFNEhVs1KIk=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/interestexpense.asp_final-97773a4d154444b4a5fb30fbbae4102d.png)

*Companies with too much debt may face financial distress from reduced cash flow. — Investopedia / Ellen Lindner*

## How Interest Expenses Work

Interest 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](https://www.investopedia.com/terms/c/currentliabilities.asp)” section of the balance sheet. Conversely, if interest has been paid in advance, it would appear in the “[current assets](https://www.investopedia.com/terms/c/currentassets.asp)” section as a prepaid item.

While mortgage interest is tax-deductible in the United States, it is not tax-deductible in Canada. A loan's purpose is also critical in determining the 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)](https://www.investopedia.com/terms/r/rrsp.asp), [Registered Education Savings Plan (RESP)](https://www.investopedia.com/terms/r/resp.asp), or Tax-Free Savings Account—interest expense is not tax-deductible.

### Amount of Interest Owed

The [amount of interest expense](https://www.investopedia.com/ask/answers/121814/what-good-interest-coverage-ratio.asp) 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.

### Effect on Companies

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 servicing 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) to see how capable companies are at managing their debt.

## Interest Coverage Ratio

The [interest coverage ratio](https://www.investopedia.com/terms/i/interestcoverageratio.asp) is defined as the ratio of a company’s operating income (or EBIT—[earnings before interest or taxes](https://www.investopedia.com/terms/e/ebit.asp)) 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.

**Interest coverage ratio = EBIT ÷ interest expense**

### Example

So, 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 ($80 million ÷ $8 milliion).

This figure shows that the company can comfortably meet its interest obligations.

Conversely, if EBIT were to fall below $24 million, the interest coverage ratio of less than 3 could signal that the company may have a hard time staying solvent. An interest coverage ratio of less than 3 is often seen as a red flag.

> **Article Sources**
>
> 1.  Internal Revenue Service. "[Topic No. 505, Interest Expense](https://www.irs.gov/taxtopics/tc505)."
>     
> 2.  Government of Canada. "[Income Tax Folio S3-F6-C1, Interest Deductibility](https://www.canada.ca/en/revenue-agency/services/tax/technical-information/income-tax/income-tax-folios-index/series-3-property-investments-savings-plans/series-3-property-investments-savings-plan-folio-6-interest/income-tax-folio-s3-f6-c1-interest-deductibility.html)."