Interest Expense Formula

Formula to Calculate Interest Expense

The formula to calculate interest expense are of two types – the first method is called as simple interest method in which interest expense is calculated by multiplying principal outstanding, rate of interest and the total number of years and the second method is called as compound interest method where interest amount is calculated by the way of multiplying principal by one plus annual rate of interest raised to number of the compound period less one and lastly resultant value is deducted from total initial amount.

Calculate Interest Expense (Step by Step)

#1 – Simple Interest Method

In the case of a simple interest method, the interest expense can be calculated by multiplying the outstanding principal, the annualized rate of interest, and the number of years. Mathematically, it is represented as,

Interest Expense SI = P * t * r

where,

  • P = Outstanding principal
  • t = Number of years
  • r = Annualized rate of interest

For simple interest method, the interest expense can be determined by using the following steps:

  1. Firstly, determine the annualized rate of interest for the given debt level. The annualized rate of interest is denoted by ‘r,’ and it is clearly stated in the loan agreement.

  2. Next, determine the outstanding principal of the loan, i.e., the opening balance of the loan principal at the beginning of the year. It is denoted by ‘P,’ and it can be confirmed from the accounts department of the company or the loan schedule.

  3. Next, figure out the tenure of the loan, i.e., no. of years remaining till maturity. The tenure of the loan is denoted by ‘t’ and is available in the loan agreement.

  4. Finally, in case of simple interest method, the interest expense during a period can be calculated using the formula as, Interest expense SI = P * t * r

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For eg:
Source: Interest Expense Formula (wallstreetmojo.com)

#2 – Compound Interest Method

In the case of the compound interest method, the interest expense can be calculated based on the outstanding principal, the annualized rate of interest, the number of years, and the no. of compounding per year. Mathematically, it is represented as,

Interest Expense CI = P * [(1 + r/n)t*n – 1]

where,

  • P = Outstanding principal
  • t = Number of years
  • n = No. of compounding per year
  • r = Annualized rate of interest

For the compound interestCompound InterestCompound Interest is the interest earned from the initial Principal & the previously accumulated Interest amount. This is also known as “Interest on Interest” & it is always higher than the Simple Interest. read more, the interest expense can be determined by using the following steps:

  • Step 1 to Step 3: Same as above.
  • Step 4: Next, the no. of compounding periods per year is determined. Usually, the no. of compounding periods in a year can be 1 (annually), 2 (half-yearly), 4 (quarterly), etc. The number of compounding periods per year is denoted by ‘n.’
  • Step 5: Finally, in case of simple interest method, the interest expense during a period can be calculated using the formula as,

Interest expense CI = P * [(1 + r/n)t*n – 1]

Examples

You can download this Interest Expense Formula Excel Template here – Interest Expense Formula Excel Template

Example #1

Let us take an example where the interest expense is to be calculated on a sum of $1,000 for one year with a simple interest of 12%.

  • Given, Principal, P = $1,000
  • The rate of interest, r = 12%
  • No. of years, t = 1 year
Example 1

As per simple interest method, calculation of the interest expense will be,

Interest Expense Example 1.1png

= P * r * t

= $1,000 * 12% * 1

Interest Expense Formula Example 1.2png

Example #2

Let us take an example where the interest expense is to be calculated on a sum of $1,000 for one year with an interest rate of 12% on the compounding method basis. The compounding is done:

  • Daily
  • Monthly
  • Quarterly
  • Half-yearly
  • Annual

Given, Principal, P = $1,000

Rate of interest, r = 12%

No. of years, t = 1 year

#1 – Daily Compounding

Since daily compounding, therefore n = 365

As per compound interest method, the interest expense can be calculated as,

= P * [(1 + r/n)t*n – 1]

= $1,000 * [(1 + 12%/365)1*365 – 1]

= $127.47

#2 – Monthly Compounding

Since monthly compounding, therefore n = 12

As per the compound interest method, the interest expense can be calculated as,

= P * [(1 + r/n)t*n – 1]

= $1,000 * [(1 + 12%/12)1*12 – 1]

= $126.83

#3 – Quarterly Compounding

Since quarterly compoundingQuarterly CompoundingThe compounding quarterly formula depicts the total interest an investor can earn on investment or financial product if the interest is payable quarterly and reinvested in the scheme. It considers the principal amount, quarterly compounded rate of interest and the number of periods for computation.read more, therefore n = 4

As per the compound interest method, calculation of interest expense will be,

= P * [(1 + r/n)t*n – 1]

= $1,000 * [(1 + 12%/4)1*4 – 1]

= $125.51

#4 – Half Yearly Compounding

Since half yearly compounding, therefore n = 2

As per the compound interest method, calculation of interest expense will be,

= P * [(1 + r/n)t*n – 1]

= $1,000 * [(1 + 12%/2)1*2 – 1]

= $123.60

#5 – Annual Compounding

Since annual compounding, therefore n = 1,

As per the compound interest method, calculation of interest expense will be,

= P * [(1 + r/n)t*n – 1]

= $1,000 * [(1 + 12%/1)1*1 – 1]

= $120.00

From the above results, it can be inferred that all other factors being equal, simple interest method and compound interest method yield equal interest expense if the no. of compounding per year is one. Further, under the compound interest method, the interest expense increases with the increase in the number of compounding per year.

The Below table provides the detailed calculation of the interest expense for various compounding periods.

Example 2.1png

The below graph shows the Interest Expense for various compounding periods.

Interest Expense graph

Relevance and Uses

From a borrower’s point of view, it is important to understand the concept of interest expense since it is the cost incurred by the entityCost Incurred By The EntityIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. read more for borrowed funds. The interest expense is a line item that is captured in the income statement as a non-operating expenseA Non-operating ExpenseNon operating expenses are those payments which have no relation with the principal business activities. These are the non-recurring items that appear in the company's income statement, along with the regular business expenses.read more. It denotes the interest to be paid on the borrowings – which may include corporate loans, bonds, convertible debt or other similar lines of creditLines Of CreditA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a business.read more. The significance of interest expense further increases because it is tax-deductible for both companies and individuals in most countries. Therefore, it is vital to understand the interest expense of a company as it would help in understanding its capital structure and financial performance.

Recommended Articles

This has been a guide to the Interest Expense Formula. Here we discuss how to calculate Interest Expense using 2 different methods, i.e., simple interest method and compound interest method along with practical examples and downloadable excel template. You may learn more about Accounting from the following articles –

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