Interest and Expense on the Income Statement

Investing Lesson 4 - Analyzing an Income Statement

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There is a section of the income statement that contains the line items called interest income and interest expense. These are particularly important accounts when you are dealing with businesses in industries or sectors such as banking, insurance, and real estate.

Some companies will generate considerable income from interest, often in the form of bonds. But most firms will actually show interest expense on their income statement because they've borrowed money to fuel growth and fund operations. The following breaks down how companies report their interest income or expense.

Interest Income on the Income Statement

Companies sometimes keep their cash in short-term deposit investments such as certificates of deposit with maturities up to twelve months, or savings accounts, and money market funds. The cash placed in these accounts earns interest for the business, and that money is recorded on the income statement as interest income.

For some companies, interest income is relatively small or even meaningless. For others, such as insurance underwriters, it is of enormous importance. Property and casualty insurance companies such as The Travelers, Progressive, and Allstate invest a substantial percentage of book value and policyholder "float," which is money they hold until policy claims are paid out but do not own, in investment-grade bonds, particularly corporate bonds. Changes in interest rates can result in considerable changes, for better or worse, to the profitability of the firm. 

A real-world illustration: In 2014, the insurance industry began approaching a period during which the bonds bought many years in the past were coming up for maturity. It was problematic because many of those bonds were purchased a time when interest rates were much higher. Thus, they faced a situation where higher interest bonds were being replaced by those with lower rates.

If interest rates stay at or near zero percent for an extended length of time, it could result in a prolonged, perhaps severe, drop in the profitability of the insurance industry as a whole. It would mean the price-to-earnings ratios of many insurance companies are higher than they appear. 

For those who take a valuation-based approach to build a portfolio, that's useful information to take into consideration when determining the appropriate price to pay for an ownership stake in these companies.

Interest Expense on the Income Statement

Far more common, and often much more important for most types of businesses, interest expense on the income statement represents the cost of borrowing money from banks, bond investors, and other sources to meet short-term working capital needs, add property, plant, and equipment to the balance sheet, acquire competitors, or increase inventory

For businesses that are asset intensive, a rise in interest rates can be a major headwind, reducing earnings the same way they benefit banks and insurance companies. The primary defense is for a firm's management to lock in debt maturities as far into the future as possible so they can continue to pay the lowest imaginable interest rates while allowing inflation to erode the actual purchasing power they must return. 

This is the reason you must dig into the regulatory filings and look at the debt maturity schedule, and try to predict what refinancing at the rates likely to be in effect at the time will do to the bottom line.

Some income statements report interest income and interest expense separately as their own line items. Others combine them and reported them under either "Interest Income - net" or "Interest Expense - net," depending upon which is higher. Net refers to the fact that management has simply subtracted interest income from interest expense to come up with one figure. In other words, if a company paid $20 in interest on its debts and earned $5 in interest from its savings account, the income statement would only show "Interest Expense - Net" of $15.

The amount of interest a company pays in relation to its revenue and earnings is tremendously important. To gauge the relation of interest to earnings, investors can calculate the interest coverage ratio.