Interest Expense

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Interest Expense is the amount of money a company pays in interest on its debt.

A company's interest expense tells an investor how much of the company's cash flow is going to pay the interest on its debt.

Interest expense is most commonly used to calculate a company's Interest Coverage Ratio, calculated by dividing a company's Earnings Before Interest and Taxes (EBIT) by its interest expense. Investors use this ratio as a yardstick of the company's financial health. Larger values are better. A ratio of one indicates all of the company's cash flow is used to pay interest - an extremely unhealthy scenario. Ratios below one indicate the company is not generating enough cash even to pay the interest on its debt.

Example

Company ABC borrowed $500,000 from a bank and promised to pay 10% interest over the course of the year with payments occurring at the end of each quarter. At the end of each quarter, the interest expense is $12,500 (500,000 X 0.10 X1/4 = 12,500).

Because interest is accrued, a company will still report interest expense each quarter even if it only pays interest once a year (ie, it will report 1/4 of the expense each quarter, rather than the total all at once).

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