Most businesses carry some debt and most pay interest on that debt. Some businesses loan money or other assets and receive interest payments. Do you know how to calculate, pay, collect and record interest? Here are some basic knowledge I am going to reveal in brief: Exploring types of interest, delving into credit interest, booking interest, paying long-term debt interest, recording interest income. So read on
Determining Interest Types
Financial institutions use two different types of interest calculations when determining how much to pay you in interest for money on deposit or calculating how much you will pay them on a loan or credit card — simple interest and compound interest.
Simple interest is easy to calculate. Here’s the formula for calculating simple interest:
Principal × Interest rate × n = Interest
You have a $10,000 savings account earning 3 percent interest per year. If you want to know what the total interest earned over three years, here how it is simply calculated:
Interest = $10,000 × .03 × 3 = $900
Compound interest is more complicated to calculate because interest is not only charged on the amount you have on deposit, it is also calculated on the interest earned during the time you have it on deposit. So when you calculate compound interest you must add the interest earned the previous period to the balance before calculating the interest earned during the new period. Here’s the formula for calculating compound interest for a three-year deposit:
Interest for Year one = Principal × Interest rate
Interest for year two = (Principal + Interest earned) × Interest rate
Interest for year three = (Principal + Interest earned) × Interest rate
Note: You would repeat this method of calculation for the life of the deposit.
To Calculate the compound interest on a $10,000 deposit at 3% for three years, are as follows:
Year one: $10,000 × .03 = $300
Year two: $10,300 × .03 = $309
Year three: $10,609 × .03 = $318.27
Total interest earned in three years = $927.27
When you are taking a loan, you always want to be sure you will be paying simple interest. When you are opening a savings account or any other type of savings instrument with a financial institution you always want to be sure you will earn compound interest.
Even compound interest can be paid differently. Some banks will compound your earnings monthly, which means interest earned will be added to your balance before the next monthly interest calculation. For other types of accounts interest is only compounded annually. So always look for a bank that compounds your savings monthly.
Determining Interest on Debt
Businesses borrow money for both short-term (less than 12 months) and long-term business needs.
Short-term debt usually includes credit cards and lines of credit.
Long term debt can include a multi-year loan for a vehicle or 15 or more year loan for a mortgage. Any money paid toward interest in the current year is shown as an interest expense on the Income Statement.
As you know from your personal credit cards, if you pay the bill in full at the end of each month, you don’t have any interest charges. But, if you don’t pay the balance in full each month, interest is charged based on a daily periodic interest rate, which means you start paying interest from the day you make a purchase. The daily periodic rate is calculated by dividing the annual rate by 365 days. Here is a table shows you a typical credit card interest charge:
You will find a similar table on your credit card bills, but the actual interest rates may be different depending on your credit card agreement
Example: Using the Table, Here is how to calculate the interest for a purchase of $150 made on April 15, andthe month closes on April 30. Assume the bill is not paid in full each month.
Interest: $150 × 0.034076 = $5.114
So, now you can see that interest compounded daily can be a lot more expensive than a simple annual interest rate. Credit cards are definitely the most expensive way to carry a loan. You won’t be calculating interest. Instead you’ll be using the amount of interest charged shown on the monthly credit card bill as your interest expense.
Most businesses seek better rates for short-term borrowing by using lines of credit. When using this type of credit line, you draw cash when needed and pay interest on the amount of the loan balance, but it is not compounded daily like a credit card.
A businessman draws $1,000 from his line of credit with an 8% interest rate. Here is how to calculate interest he will pay each month that he has the loan (assume he pays the total interest due each month, which means the balance will stay constant each month).
Annual Interest = $1,000 × .08 = $80
Monthly Interest Due = 80/12 = $6.67
Recording Interest on Short-term Debt
Recording interest on short-term debt is simple. When the cash is initially taken out of the account, you would record the cash receipt and the increase in a liability this way:
[Debit]. Cash = $1,500
[Credit]. Credit Line Payable = $1,500
As you make interest payments, you would record the decrease in Cash and an Interest Expense. If you also paid toward the balance of the loan you would add that to the entry this way:
[Debit]. Credit Line Payable = $150
[Debit]. Interest Expense = $10
[Credit]. Cash = $160
You would record a cash payment on a line of credit of $500 plus $35 interest as follows:
[Debit]. Credit Line Payable = $500
[Debit]. Interest Expense = $35
[Credit]. Cash = $535
Separating and Paying Interest on Debt
When a company takes on long-term debt, which means debt to be paid over more than 12 months, then the debt must be separated into current and long-term debt. The current debt will be the amount of cash that must be paid during the current year, which will include both interest and principal payments. Any amount remaining would be long-term debt. You would need to ask your bank for an amortization chart in order to determine how much of each payment on the long-term debt goes toward interest and how much goes toward principal.
Recording (booking) Interest Income
Many businesses earn interest from money in savings accounts, money market accounts or certificates of deposit or other investment vehicles. You need to record any interest earned for the business in an Interest Income account, which will appear on the Income Statement.
Luckily you shouldn’t have to calculate that interest. Your bank statement will indicate the amount of interest earned.
When you get the statement from the bank you find that your business account earned $25 in interest income. How would you record that transaction in the books?
Here is the entry would look like:
[Debit]. Cash = $25
[Credit]. Interest Income = $25