Interest and Expense on the Income Statement
Investing Lesson 4 - Analyzing an Income Statement
The next section of the income statement with which we are going to deal gets into interest income and interest expense. These are particularly important when you are dealing with certain types of businesses in industries or sectors such as banking, insurance, and real estate so pay careful attention to this section if you are considering investing in the stock of a company operating in or around these areas of the economy.
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, savings account, and money market funds. The cash placed in these accounts earn interest for the business, which is recorded on the income statement as interest income.
For some companies, interest income on the income statement is small or meaningless. For others, such as the insurance underwriters I mentioned a moment ago, it is of enormous importance. Property and casualty insurance companies 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, even decades, 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 and enjoyed far fatter bond coupons than anything then available on the market. 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.
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, an increase 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. It is the reason you must dig into the regulatory filings and look at the debt maturity schedule; anticipate and 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 whether there is more of the former or latter. 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.