Companies sometimes keep their cash in short-term deposit investments such as certificates or deposit with maturities up to twelve months, savings account, and money market funds. The cash placed in these accounts earn interest for the business, which is recorded on the income statement as interest income.
For some companies, interest income is small or meaningless. For others, such as an insurance company that generates profit by investing the money it holds for policyholders into interest paying bonds, it is a crucial part of the business. For example, in 2014, the insurance industry is approaching a period where the bonds held in the corporate portfolios, the ones that were bought back when interest rates were much higher, will be coming up to their maturity dates. That means the money will have to be put into lower yielding bonds, causing a substantial hit to profits; something very few investors are factoring into their calculation at the moment, causing insurance stocks to be overvalued because past earnings aren't indicative of future interest income.
Interest income will fluctuate each year with the amount of cash a company keeps on hand and the general level of interest rates as set by the Federal Reserve (to learn more about how this is done, read The Federal Reserve and Interest Rates.
Companies often borrow money in order to build plants or offices, buy other businesses, purchase inventory, or fund day-to-day operations. The borrowed money is converted to an asset on the balance sheet (e.g., if a business borrows $1 million to build a distribution center, the distribution center would add $1 million of assets to the balance sheet after the cash was spent.) The interest a company pays to bondholders, banks, and private lenders, on the other hand, is an expense for which it receives no asset. As a result, interest expense must be accounted for on the income statement.
Some income statements report interest income and interest expense separately, while others report interest expense as "net". Net refers to the fact that management has simply subtracted interest income from interest expense to come up with one figure. In other words, if a company paid $20 in interest on its bank loans, and earned $5 in interest from its savings account, the income statement would only show interest expense - net $15.
The amount of interest a company pays in relation to its revenue and earnings is tremendously important. To gauge the relation of interest to earnings, investors can calculate the interest coverage ratio.
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.