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 section of the balance sheet conversely if interest has been paid in advance it would appear in the current assets section as a prepaid item while mortgage interest is tax deductible in the united states 1 it is not tax deductible in canada the 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 registered education savings plan resp or tax free savings account interest expense is not permitted to be tax deductible 2the amount of interest expense 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 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 serving 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 interest coverage ratiothe interest coverage ratio is defined as the ratio of a company s operating income or ebit earnings before interest or taxes 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 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 which shows that the company can comfortably meet its obligations to pay interest conversely if ebit falls below 24 million the interest coverage ratio of less than 3 signals that the company may have a hard time staying solvent as an interest coverage of less than 3 times is often seen as a red flag 