Whether you're running your own business or looking into the workings of others, the income statement is a go-to resource for learning about how a company earns money from interest, and also how it might be funded. You can find what you're looking for in a section of the company's income statement that contains two line items called "interest income" and "interest expense."
Some companies earn a great deal of income from interest, often in the form of bonds. But most firms that show an interest expense on their income statement do so because they've borrowed money to fuel growth and to fund their operations. The following breaks down some items carrying interest, whether from income or expenses, that a company might report on its income statement, and what it might mean for the bottom line.
How to Read the Interest Figures
Some income statements report interest income and interest expense as their own line items. Others combine them and report them under either "Interest Income - net" or "Interest Expense - net," based on whichever is higher. Net is simply the total sum, and it refers to the fact that the people who manage the funds have added interest income to 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.
Why Would a Company Have Interest Income?
Many companies keep their cash in the types of savings accounts that earn money in the short term, such as money market accounts or certificates of deposit that will mature in twelve months. The cash placed in these accounts provides a passive stream of income from interest, and that money is recorded on the income statement as interest income.
Interest income is important to watch when you are dealing with businesses in industries or sectors that have very low operating costs and spend most of their budget on labor. (Think: banking, insurance, and real estate.) Without the need to spend on supplies, parts, or other tangible assets, a good portion of the budget is freed up for investing.
A Case Study: The Insurance Industry
Interest income can be very small, or even close to nothing for some companies. For others, such as banks and insurance underwriters, it is of huge value. Property and casualty insurance companies invest a large portion of their book value or other cash assets into types of funds that will earn interest on a steady basis, such as high-yield bonds. For insurance companies, these holdings are mostly corporate bonds.
Changes in interest rates can result in changes for the firm's profit as well, for better or worse. When interest rates go up, they are able to purchase new bonds with higher yields, which can then be saved or reinvested to continue the growth. When interest rates fall, bond holdings may gain in market value but new bonds purchased will carry lower yields.
Bonds are known to be relatively safe holdings, and they hardly ever lose money, but it does happen. For instance, in 2014 the insurance industry began to reach a point where the bonds bought many years earlier were reaching their date of maturity. That was an issue because many of those bonds had been purchased at a time when interest rates had been much higher. Thus, they faced a problem where higher-interest bonds were being replaced by those with lower rates.
The extra money that insurance companies use to invest is called "float." Float comes from the premiums that policyholders pay each month. It is held in a pooled fund (along with the bills paid from all holders, over time) until it is needed to cover claim payouts. In the meantime, though insurance companies don't own the money outright, they can use this "floating" fund to invest as they please.
What Does This Mean for Stockholders?
If interest rates stay at or near zero percent for a long stretch of time, it could result in a prolonged, perhaps severe, drop in the profits of the insurance industry as a whole. As a result, the price-to-earnings ratios of many insurance companies are higher than they appear.
This is useful information for anyone who invests in this market and who takes a valuation-based approach to their portfolio, since it affects the price they'll be willing to pay for an ownership stake in these companies. That way, the company can continue to pay the lowest interest rates and hope that inflation will chip away at the value of the actual amount they must return.
Why Would a Company Have Interest Expense?
Far more common, and often much more important for most types of businesses, is the interest expense on the income statement. This figure shows how much it costs to borrow money from banks, brokers, and other sources to meet short-term needs, such as working capital, buying property, buying plant equipment or supplies, or bulking up on inventory. Money can even be borrowed to buy out competitors.
The amount of interest a company pays, compared to its revenue and earnings, is shown in the interest coverage ratio. A low ratio reflects a high debt burden, and it hints that a company may be in trouble.
What Does This Mean for Stockholders?
Asset-intensive companies are those that spend a large portion of their budgets on things like machine parts, equipment, and other tangible assets, to produce goods or services. (Think: airports, auto plants, hotels, or water-treatment plants.) They have very little extra cash to spend on stocks, bonds, or other means to earn passive streams of income.
For these types of businesses, a rise in interest rates can be a major headwind. One line of defense would be to lock in debt maturities as far into the future as possible. That way, the company can continue to pay the lowest interest rates and hope that inflation will chip away at the value of the actual amount it must return.
The savvy stockholder can dig deeper by looking at the debt schedule in a company's regulatory filings. If you can tell when a certain debt will mature, you can try to predict the interest rates at that time. Then, you can play out what would happen if a company were to refinance its debt at that moment, and how that would affect its bottom line.