Tag Archives | interest rates

Interest Expense Formula

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Interest Expense

Interest Expense Formula

Interest expense calculations involve 4 parts: Principal, Rate, Time, and Compounding.

Simple interest expense formula (which excludes compounding): Interest Expense = Principal X Rate X Time

Compound interest rate formula: Principal X (1+ (R / N))(N X T) Where: R = Interest rate N = Number of times interest is compounded in a year T = Time in years

Interest Expense Calculation Principal = $50,000 Interest Rate = 7% Time = 3 years

$50,000 X .07 X 3 = $10,500 in interest expense

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Interest Expense Journal Entry

When recording an interest expense journal entry, the interest expense account is debited and the cash account or the interest payable account is credited. This represents money coming out of the cash or interest payable account and going into the interest expense account.

If the interest payment has already been recorded as a liability, it may show up on the balance sheet as interest payable. If it has not already been recorded as a liability on the balance sheet, the amount used to pay for the interest expense will come out of the cash account or the prepaid interest account on the balance sheet. This journal entry is made when the interest expense is recognized. Depending on the circumstances, the journal entry may look like one of the following:

                                 Debit                Credit

Interest Expense                  $1,000
Cash                                          $1,000

Interest Expense                  $1,000
Interest Payable                              $1,000

Interest Expense                  $1,000
Prepaid Interest                              $1,000

Interest Expense Example

Dwayne has started a company which rents party equipment. The equipment in which he rents are too expensive to buy straight up. Dwayne is considering financing some equipment, mainly the additional trucks he needs to move supplies, so that he could provide a high level of service. Dwayne wonders what his interest expenses would be. He looks on the web to find an “interest expense calculator”. Dwayne calculates these results:

Principal: $50,000 Interest: 7% Time: 3 years Compounding: None

So:

$50,000 X .07 X 3 = $10,500 in interest expense

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interest expense formula

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interest expense formula

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How Low is Too Low?

Recently, I read an article by Dan Patrick of the Wall Street Journal detailing how superlow interest rates, while certainly beneficial to borrowers, are hurting bank profits and the industry’s ability to recover from the financial crisis.  According to Mr. Patrick, some of the negative effects of these artificially low rates we could see are more Americans being pushed out of the financial system altogether due to higher costs for banking services as well as an accelerated “shakeout” of smaller banks.  This begs the question, how low is too low?  Here’s an excerpt from the article:

Superlow U.S. interest rates are squeezing bank profits, complicating the industry’s nascent recovery from the financial crisis.

An important gauge of lending profitability, known as net interest margin, has dropped to its lowest level in three years. The measure tracks how much banks earn when they borrow from depositors and then lend or invest those funds.

The squeeze is the flip side of the Federal Reserve Board’s four-year effort to revive the sluggish U.S. economy, with near-zero short-term interest rates and repeated rounds of bond purchases that aim to reduce long-term rates as well. Ten-year U.S. Treasury yields hit 1.43% in July, their lowest level since World War II.

Banks will be forced to consider new ways to make money by changing the services they offer, industry observers said. At the same time, higher costs for banking services could push more Americans out of the financial system altogether, adding to the millions of customers viewed by regulators as under-banked, or lacking access to affordable financial services.

 

Read the full article here.

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Create Jobs By Reducing Risk

There has been a lot of press lately regarding all of the cash that companies are sitting on. In addition, the government is talking about making it easier for companies to borrow money. Between the cash on hand and the loans they obtain companies will then be able to hire employees. It just doesn’t work that way!

The worst part of being a manager or business owner is letting people go. Consequently, employers are not going to hire new employees until they are confident that they have enough sales demand to prevent them from having to let them go in six months.

People are sitting on cash because they have no confidence. In order to increase confidence you must reduce risk.

Whether you are a consumer or business any time you chose to spend money you are taking on risk. Rishk that you will have a job or a sale in the future. That is economic risk. You also take a risk that you will perform. That is execution risk. Finally, you take the risk that the rules and laws will be consistent. That is legislative risk.

We have had a period where the economic risk is higher than normal. Coupled on top of that is the legislative risk. How much tax am I going to pay? What new regulations are going to be imposed? What are my health care costs in the future?

Any time you have such high risk in the business environment people are going to “sit on their hands” until things stabilize. We need to slow down the pace of change in order for consumers and the business community to feel confident enough to spend money that demands jobs!

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Fed Open to Raising Rates….

Fed Chief Ben Bernanke recently stated that the Fed might raise rates to cut off future financial asset bubbles, but mounted a defense against critics who claim that the Fed’s failure to do so led to the most recent financial asset bubble.

I think this belies the dichotomy present in the mandate put to the Fed by Congress. Per the Humphrey-Hawkins Full Employment Act, the Fed is to pursue actions which promote….full employment, with low inflation and economic growth.

That seems like a recipe for financial asset bubbles.

While the Congress debates auditing the Federal Reserve, perhaps it should reconsider the mandate it has placed on the Fed.

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Bernanke sees low rates, sluggish growth ahead

Federal Reserve Chairman Ben Bernanke stated today that he expects interest rates to remain low for an “extended period” while the economy struggles out of the recession, given high unemployment and tight credit. He expects rates to remain low as, according to him, inflation is under control. Is your company prepared to face an extended, slow recovery? Have you factored this into your projections? Do you maintain monthly financial projections, complete with a cash flow forecast, and update those with actuals?

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Bernanke Predicts the Future!

Fed Chairman Ben Bernanke described the future in a opinion article in The Wall Street Journal today. Mr. Bernanke goes to some detail explaining how he is going to suck out the liquidity sloshing around in the economy. It makes quite a bit of sense. I can see how the next phase of the economy might play out.

The bottom line of the Fed’s exit strategy is that interest rates are going to start rising as they remove the liquidity from the financial system. Just as low interest rates are in effect right now, so will higher interest rates once the cash is removed from the banking system.

Entrepreneurs and CFO’s should be projecting every increasing interest rates over the next three to five years. When structuring partnerships or equity arrangements allow for much higher interest rates to be in effect. You might consider putting a ceiling and floor on interest rates with lenders or investors.

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