Lesson 3 of 8
The price of credit in a filing
Interest expense on the income statement, interest paid in the cash flow statement, interest capitalised into an asset. Three places, and a filer may use one.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- The cost of borrowing appears in up to three places in one annual report, and a company can legitimately report zero in the first of them.
- Interest capitalised into an asset leaves the income statement entirely and comes back later inside cost of sales.
- A zero on the interest line is a reading, not an absence, and it changes which ratio can answer a credit question at that filer.
Finding the price of credit in a company's accounts sounds like the easiest step in this whole track. It is the one most readers get wrong, because they look in one place and stop.
Interest expense reported by one filer, eight consecutive fiscal years
- Interest expense on the income statement
- Interest paid, from the cash flow statement
Show the numbers
| Interest expense on the income statement | Interest paid, from the cash flow statement | |
|---|---|---|
| FY12 | 0$m | 1.2$m |
| FY13 | 0$m | 18.2$m |
| FY14 | 0$m | 10.1$m |
| FY15 | 0$m | 23.9$m |
| FY16 | 0$m | 12.1$m |
| FY17 | 0$m | 21.6$m |
| FY18 | 0$m | 20.8$m |
| FY19 | 0$m | 35.4$m |
Place one: the income statement
The line most people mean by interest expense. It is what the coverage ratio divides into operating income, and it is the figure ValueScreener reads first.
It can be zero at a company with billions of dollars of borrowings, and the chart above is a real instance: Toll Brothers tagged interest expense as zero in every one of the eight fiscal years from 2012 to 2019. The company was not debt free in any of them.
Place two: the cash flow statement
Cash interest paid, usually in a supplemental disclosure at the foot of the statement or in the notes. It is a cash figure rather than an accrual figure, so it will not agree with the income statement even at a company that reports both, and it moves with when coupons fall due.
At the same filer, over the same eight years, interest paid runs from 1.2 million dollars in fiscal 2012 to 35.4 million in fiscal 2019. The obligation was always there and always disclosed. It was simply not on the line a coverage ratio reads.
Place three: inside an asset
Under ASC 835-20, interest incurred while an asset is being readied for its intended use is capitalised into the cost of that asset rather than expensed. At a homebuilder the asset is inventory, so the interest goes into the carrying value of land and homes under construction and comes back through cost of sales as those homes close, years later and blended into gross margin.
This is not a loophole and it is not aggressive accounting. It is the required treatment. Its consequence for a reader is exact: at such a filer the cost of credit is inside gross margin, which means every margin computed above the interest line already contains it.
What to do with three numbers
Read all three, and know which question each answers. The income statement figure is what a coverage ratio uses and what most published screens use. The cash figure is what actually left the company. The capitalised figure is the part that will arrive later, in a different line, at a margin you are probably already looking at.
Where the first is zero, the third is usually why, and the second is the evidence that the obligation exists.
Check yourself
A filer reports zero interest expense on its income statement across eight consecutive years. What does that establish?
- The company has no borrowings
- Only that the cost is not on that line, which at a company readying long-lived assets usually means it was capitalised
- That the filing is in error
Show the answer
Answer: B.
The same company disclosed interest paid of between 1.2 and 35.4 million dollars in those years. The obligation was disclosed; it was simply not on the income statement line.Where does capitalised interest end up?
- It is never recognised
- In the carrying value of the asset, and later in cost of sales when that asset is sold
- In financing cash flows only
Show the answer
Answer: B.
ASC 835-20 requires it to be capitalised into the asset being readied. At a homebuilder that asset is inventory, so it reaches the income statement through gross margin.Why does the product return n/a rather than a very large number for interest coverage at such a filer?
- Because the data is missing
- Because a positive operating income over a zero interest expense has no meaningful answer, and a large number would report a debt-free company
- Because coverage is not a useful ratio
Show the answer
Answer: B.
The refusal is the accurate reading. Printing a high coverage figure would describe a company with no borrowings, which is not what the filing says.Sources
- Toll Brothers, Inc., annual reports on Form 10-K for fiscal years 2012 through 2019, for interest expense as tagged on the income statement and interest paid as disclosed with the cash flow statement.
- ASC 835-20, Capitalization of Interest: interest incurred while an asset is being readied for its intended use is capitalised into the cost of that asset.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The eight years shown are the years this filer tagged an interest expense figure in XBRL. Years outside that range are not evidence of anything either way.
- Interest paid is a cash figure and moves with coupon dates. It is not a restatement of the accrual figure and the two are not expected to agree.
- Nothing here is a view on Toll Brothers or on any security.