What it is:
How it works (Example):
Let's assume you need $500,000 to buy a house. The "price" of borrowing that credit risk, rates, and a variety of other conditions.is interest, and it is expressed as a percentage of the amount of you obtain. The borrower pays the interest to the , and those interest payments are the borrower's interest expense. The rate of interest reflects the of , the borrower's
Interest can be fixed or variable, meaning that the rate either stays the same through or changes according to a predetermined formula. That means interest expense often changes over time.
In banking relationships, when a person savings account or certificate of , the person is acting as a to the bank and thus receives interest from the bank. In this case, it is the bank that incurs the interest expense.in a
From an accounting perspective, it is important to remember that interest expense isn't always the exact amount of physically paid to a borrower in the . For example, if Company XYZ borrows money from Bank ABC and makes quarterly interest payments, Company XYZ might only be cutting a check to Bank ABC in, say, March, June, September, and December. However, the accrual method of accounting requires Company XYZ to attribute some of that interest expense to all the other months in the so that the for, say, January reflects some interest expense even though the company didn't transfer any to the in that month.
Why it Matters:
When interest expense is too high, it can wreck a company or a household. In general, high interest expense can indicate that a company is overleveraged, which is whyand are particularly interested in measuring how much a company or individual brings in per month before lending.
Because a company’s failure to meet interest payments (that is, pay its interest expense) usually results in default, the interest coverage ratio is of particular interest to and and acts as a margin of safety. However, because the interest coverage ratio is based on current and current expenses, it primarily focuses a company’s short-term ability to meet interest obligations.
Some industries tend to have higher interest expenses than others, and cyclical companies in particular can experience significant swings in their interest expense (especially during recessions) because they may need to borrow temporarily to get through seasonal lows during the. Thus, comparison of interest expense or any ratios involving interest expense is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.