Interest expense represents the cost of money you've borrowed on loans and lines of credit. It's a way of showing how much interest the business has accrued during a year, a month or a quarter – not how much interest the business has actually paid. Monitoring your interest expense in relation to revenue is incredibly important for determining how much of your cash flow is going towards servicing debt.
How to Calculate Interest Expense
To calculate the interest expense on money you have borrowed, you need three pieces of information:
- The amount of principal outstanding on the loan
- The interest rate, specified on an annualized or full-year basis. If the loan document specifies a monthly interest rate, use an online calculator to convert this to an annual rate
- The time period over which you wish to calculate the interest expense such as the last year or quarter. A full year has the numerical value of 1; a quarter is 0.25 and a month would be one-twelfth of a year or 0.083.
Now, use the following formula to find the interest expense: principal x interest rate x time period = interest expense.
Interest Expense Example
Suppose you have borrowed $50,000 at a 6-percent annual interest rate. You're preparing your quarterly financial statements and want to know the amount of your interest liability for the past three months. The calculation is: $50,000 x 0.06 x 0.25 = $750 interest expense. The interest expense appears in the company's income statement. This lets you see at a glance how much of your cash flow is going to pay interest on your debt.
How to Lower Interest Expense
For most businesses, even a small hike in interest rates can be a major headache, taking more of your cash flow away from operations and reducing your pre-tax profit. The first line of defense is to lock down your current rate as far into the future as possible. If your current rate is too high, perhaps because of past credit mistakes, shop around for loans with lower rates. Refinancing is a good option when you've been in business for a while and have built up cash reserves and better credit. Another option is to pay down the principle on your loan. This can reduce the time it takes to pay off the balance while reducing the total interest over the lifetime of the loan.
How to Find Low-Interest Business Loans
Your first stop is to check out Small Business Administration or SBA loans, which are partially guaranteed by the government. These small business-friendly loans have long repayment terms and interest rates starting around 5.75 percent. They're a good option for profitable small businesses that have a solid two-year trading record – find a lender on the SBA website. If you're not eligible for an SBA loan, then various banks could also offer low-interest rates; it may be worth hiring a broker to help you figure out your options.
The lowest-cost loans tend to come from family members who may be prepared to loan you money at a very low-interest rate. Taking money from your nearest and dearest presents its own set of problems, however, so make sure that you both go into it with your eyes open. A lawyer can help you understand the risks.