Interest expense represents a financial obligation companies must account for in their financial statements. While it may seem like a straightforward expense, its classification in accounting can impact financial reporting, tax obligations, and business decision-making.

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Businesses, investors, and financial analysts need to understand whether interest expense is an operating expense. The classification affects net income, operating profit, and interest coverage ratios.

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An in-depth understanding of this concept enables companies to accurately assess their financial condition and make the right decisions regarding debt management and operational efficiency.

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This article provides a comprehensive understanding of how interest expenses work and their impact on a company’s financial standing.

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What Is an Interest Expense?

Interest expense is the interest a company pays on its outstanding debt over a specific period. It is recorded on the income statement under "non-operating expenses" because it is not directly related to core business operations.

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The expense is calculated based on the principal amount borrowed, the interest rate, and the loan duration.

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For example, if a company takes out a $1 million loan with an annual interest rate of 5%, the annual interest expense would be:

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Interest Expense = Loan Amount X Interest Rate = 1,000,000 × 0.05 = 50,000

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This means the company will record a $50,000 interest expense for the year.

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Why Businesses Incur Interest Expenses

Companies incur interest expenses when they finance operations, acquisitions, or expansions through borrowed funds rather than relying solely on equity or internal cash reserves.

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Highlighted below are why businesses take on debt and subsequently pay interest include:

• Capital Investment: Businesses borrow to purchase equipment, real estate, or technology to scale operations.
• Working Capital Management: Short-term loans or credit lines help cover operational costs, payroll, or inventory during cash flow fluctuations.
• Business Expansion: Companies seeking to enter new markets or launch new products often finance these efforts with debt.
• Leveraging Growth Opportunities: Businesses may use debt strategically to invest in profitable ventures, expecting higher returns than the interest.

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Common Sources of Interest Expense

Interest expense arises from various debt instruments, including:

• Bank loans
• Bonds
• Lines of Credit
• Mortgages and lease liabilities

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How Interest Expense Affects a Company’s Financial Status

Interest expense can significantly impact a company’s profitability, liquidity, and financial stability. Key effects include:

• Reduced Net Profit: Higher interest payments lower a company’s net income, affecting shareholder returns.
• Cash Flow Constraints: Large debt obligations with high interest rates can strain cash flow, limiting a company’s ability to reinvest in operations.
• Creditworthiness and Debt Ratios: A high-interest expense relative to earnings may signal excessive leverage, making it harder for a business to secure future financing.
• Tax Deductions: In many jurisdictions, interest expense is tax-deductible, reducing a company’s taxable income and overall tax liability.

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How Do You Find Interest Expenses in Accounting?

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Whether a business takes out loans, issues bonds, or uses credit lines, the associated interest payments must be recorded accurately in its financial reports.

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Interest expense is usually found in a company’s income statement (profit and loss statement) under the non-operating expenses section. Businesses that frequently use debt financing will often report significant interest expenses, which directly impact their net income.

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In addition, interest expense can be found in the:

• Cash Flow Statement: Under the operating activities section if the company uses the indirect method or under the financing activities section if the company follows IFRS reporting standards.
• Balance Sheet: While the expense does not appear here, any unpaid interest may be recorded as interest payable under current liabilities.

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Interest Expense in the Income Statement

Interest expense is reported as a separate line item in the income statement, usually below operating income but before pre-tax income (EBT - Earnings Before Tax). The standard format follows this sequence:

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• Revenue
• Less: Cost of Goods Sold (COGS)
• Gross Profit
• Less: Operating Expenses (e.g., salaries, rent, marketing costs)
• Operating Income (EBIT - Earnings Before Interest and Taxes)
• Less: Interest Expense
• Pre-Tax Income (EBT)
• Less: Taxes
• Net Income

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Since interest expense is deducted after calculating operating income, it is classified as a non-operating expense—meaning it does not directly relate to a company’s core business operations.

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However, some industries, such as banking and financial services, may consider interest expenses as part of their operating costs since lending and borrowing are integral to their business models.

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Accrual vs. Cash Basis Accounting for Interest Expense

The method a company uses to record its financial transactions determines how interest expense is reported.

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Accrual Basis Accounting (GAAP/IFRS Standard)

Under the accrual accounting method, interest expense is recorded when incurred, regardless of when the actual payment is made. This approach aligns with Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

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For instance, if a company borrows $100,000 at an annual interest rate of 5%, it will incur an interest expense of $5,000 per year. Even if the payment is made at the end of the loan term, the company will record monthly or quarterly accruals of interest expense in its income statement.

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This method provides a more accurate representation of financial status by recognizing expenses when they occur, allowing investors and stakeholders to assess a company's true profitability.

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Cash Basis Accounting

In cash basis accounting, interest expense is recorded only when the payment is made. This method is often used by small businesses and companies that do not adhere to GAAP or IFRS.

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For instance, if a business incurs a $5,000 interest expense but has not paid it by the reporting date, it will not be recorded as an expense. Instead, it will only appear in the books when the company physically pays the amount.

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While the cash basis method is simpler, it does not always present an accurate picture of a company's financial obligations. This can lead to misleading financial reports, especially when companies delay payments or have significant outstanding liabilities.

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Difference Between Interest Expense and Interest Payable

Interest payable refers to the interest a company owes to creditors but has not yet paid. It is recorded as a current liability on the balance sheet because it represents an obligation that must be settled within a short period, usually within one year.

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For example, if a business takes out a loan and incurs interest but has not yet made the interest payment, the unpaid amount is classified as interest payable.

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The main differences between interest expense and interest payable are highlighted in the table below:

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Examples to Illustrate the Difference

Interest Expense

Suppose a company takes out a $100,000 loan at a 5% annual interest rate. The interest cost for the year would be:

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100,000 X 5% = 5,000 

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This $5,000 would be recorded as interest expense on the income statement, reflecting the borrowing cost for that period.

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Interest Payable

If the company has not yet paid the $5,000 interest amount by the end of the accounting period, it will be recorded as interest payable under current liabilities on the balance sheet.

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Once the company makes the payment, the interest payable account will be reduced, and the cash or bank balance will decrease accordingly.

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How to Calculate Interest Expense

Businesses must track interest expense to manage debt effectively. Understanding how to calculate interest expense ensures accurate financial reporting.

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The standard formula for calculating interest expense is:

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Interest Expense = Principal X Interest Rate X Time Period

Where:

• Principal is the original amount borrowed or outstanding loan balance.
• Interest Rate is the annual interest rate (expressed as a decimal).
• Time Period is the portion of the year for which the interest is calculated (e.g., for six months, use 6/12).

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For compounded interest, the formula differs based on the compounding frequency (monthly, quarterly, annually). The formula for compound interest expense is:

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Where:

• A is the total amount after interest.
• P is the principal.
• r is the annual interest rate.
• n is the number of times interest is compounded per year.
• t is the loan duration in years.

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Examples of Interest Expense Calculations

Simple Interest Calculation

A company takes a $100,000 loan at an annual interest rate of 5% for one year.

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Interest Expense = 100,000 X 0.05 X 1 = 5,000 

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The company will report a $5,000 interest expense for the year.

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Monthly Interest Calculation

A business borrows $50,000 at an annual interest rate of 6% and makes monthly interest payments.

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Monthly Interest = 50,000 X 0.06 X 1/12 = 250

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The business incurs a $250 monthly interest expense.

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Compound Interest Calculation (Quarterly Compounded)

A company takes a $20,000 loan at an 8% annual interest rate, compounded quarterly for two years.

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A = 23,173.53

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Total interest expense = $23,173.53 - $20,000 = $3,173.53 over two years.

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Differences in Calculation Based on Fixed vs. Variable Interest Rates

Fixed Interest Rate Calculation

The interest rate remains unchanged throughout the loan term. The calculation uses the simple interest formula since the rate is consistent. For instance, a $50,000 loan with a 7% fixed annual interest rate will always incur a $3,500 interest expense annually.

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Variable Interest Rate Calculation

The interest rate fluctuates based on market conditions, such as changes in the prime rate or LIBOR. The calculation uses an adjusted interest rate for each period. For instance, a company borrows $100,000 with an initial 5% rate, which increases to 6% in the second year.

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For Year 1:

100,000 X 0.05 = 5,000

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For Year 2 (at 6%):

100,000 X 0.06 = 6,000

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Total two-year interest expense: $11,000.

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Is Interest Expense an Operating Expense?

No, interest expense is not an operating expense.

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Operating expenses are costs directly related to a company's core business operations, such as rent, salaries, utilities, and marketing expenses while interest expense arises from financing activities, such as loans and bonds.

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Since interest expense is related to debt financing and not daily business operations, it is classified as a Non-Operating Expense on the income statement. It appears in the non-operating section of the income statement, usually below Operating Income (EBIT) and before Net Income.

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Consider the sample income statement structure below:

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As you can see, Interest Expense appears below EBIT, showing that it is a financial (not operational) cost.

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In a nutshell, here’s why interest expense is considered a non-operating expense:

• Not Directly Related to Revenue Generation: Unlike salaries, rent, and other operating expenses, interest payments do not contribute directly to the production of goods or services.
• Financial Management Decision: Borrowing money is a strategic financial decision rather than an operational necessity for all businesses.
• Location on the Income Statement: Interest expense is listed below operating income on the income statement, reflecting its status as a financing cost rather than an operational one.
• Varies by Financing Structure: Some businesses operate debt-free, meaning they would have no interest expense, whereas operating expenses are essential and unavoidable.

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Situations Where Interest Expense Might Be Considered an Operating Expense

Although interest expense is a non-operating expense, there are some exceptions where it may be classified as an operating expense:

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Financial Institutions and Banks

In the banking and financial services sector, interest expense is considered an operating expense because:

• Banks earn revenue primarily from lending activities.
• Interest expense (paid on deposits or borrowings) is directly related to their business model.
• GAAP and IFRS allow financial institutions to report interest expense as an operational cost.

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Companies with Highly Leveraged Business Models

Some capital-intensive industries, such as real estate and utilities, rely on debt to finance operations. In such cases, businesses may include interest expense in operational calculations.

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Management and Investor Analysis

Some companies may adjust financial reports (e.g., Adjusted EBITDA) to reflect interest as an operating cost when evaluating core business performance.

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The Impact of Classification on Financial Reporting and Analysis

How a company classifies interest expense affects its financial statements, investor perception, and key financial metrics:

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Operating vs. Net Income

If interest expense were included in operating expenses, it would reduce operating income (EBIT) and impact profitability analysis.

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EBIT vs. EBITDA

Investors often use EBIT (Operating Profit) and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) to assess a company’s financial status. Since interest expense is excluded from EBIT, it ensures comparability across firms.

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Financial Ratios

Operating Margin remains unaffected by interest expense since it excludes financing costs. Net Profit Margin, on the other hand, accounts for interest expense, thereby impacting profitability analysis.

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Tax Considerations

Interest expense is tax-deductible in many jurisdictions, influencing tax liability and net income calculations.

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Wrapping Up

Understanding whether interest expense is an operating expense is important for accurate financial reporting and better decision-making. While interest expense is classified as a non-operating cost, its impact on cash flow and profitability makes it essential for founders to track and manage.

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For startup founders and business owners, staying on top of financial complexities—like interest expenses, operating costs, and cash flow—can be overwhelming. That’s where Chore comes in.

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With Chore, you can hand off tactical finance work to experts who deliver Fortune 500 precision, thereby ensuring your expenses are accurately categorized and optimized for financial success.

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By using Chore’s finance and equity management solutions, you can:

• Gain real-time visibility into your business expenses, including interest costs.
• Avoid costly errors in classification and reporting.
• Focus on scaling your business while finance experts handle the details.

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Instead of spending hours managing your books, let Chore handle the complexities while you focus on growing your business. Learn more.

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FAQs

Why is interest a non-operating expense?

Interest expense is a non-operating expense because it is not directly related to a company’s core business activities. Instead, it results from financing decisions like loans or bonds, making it separate from day-to-day operations. It appears below operating income on the income statement and varies based on a company’s capital structure rather than business performance.

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What are considered operating expenses?

Operating expenses are the day-to-day costs of running a business, directly tied to main operations. These include salaries, rent, utilities, marketing, office supplies, depreciation, inventory costs, insurance, professional fees, and software subscriptions.

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Where does interest expense go?

Interest expense appears on the income statement under non-operating expenses, thereby reducing net income. On the cash flow statement, it's recorded under operating or financing activities (depending on accounting standards). While it doesn't appear on the balance sheet, any unpaid interest is listed as interest payable under current liabilities.

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