Interest - All About Profit & Loss Statement

Updated: May 14



Welcome back to "All About The Profit & Loss Statement" series. We have covered the topics of cost of good sold (COGS), operating expenses (OPEX), and depreciation, which is the allocation of the upfront capital expenditure (CAPEX) over the asset's economic life. All of them are expenses that need to incurred before revenue can be earned. Hence, to close this funding gap, some businesses opt to borrow money and that incurs interest expense.


To better understand the interest, one has to at least develop an awareness of the general economy and market-at-large. So with that in mind, let us embark on this journey of discovery. Do leave a like or comment if you wish to drop a feedback.



TABLE OF CONTENT

  1. What is Interest?

  2. Interest Rate Spread

  3. Interest from the Perspective of Lenders

  4. Understanding Monetary Policy

  5. Fixed-Rate Amortizing Loan

  6. Fixed-Rate Vanilla Bond

  7. Variable-Rate Debt

  8. Interest Expense for Lease

  9. Interest Income


WHAT IS INTEREST?


Interest rate is the required rate of return that a lender charges the borrower for the opportunity cost of lending. Imagine other uses for your money instead of having to deposit in the bank, such as spending it on a holiday, investing in stocks or bonds, etc. By squirreling away money in a bank, you are effectively granting an unsecured loan to them. If the interest rate it offers is relatively abysmal for the level of risk, would you have second thoughts?


The interest expense is the amount that must be compensated to the lender for the use of her capital. It is based on the principal remaining, the interest rate, compounding frequency, and loan term. Conversely, interest income is the proceeds that creditor getsfor lending. The interest expense that is presented on the income statement after operating income might be the gross or net interest income (interest expense - income). Its exact nature can be found in the footnotes.


The interest rate is presented on an annual basis but its actual expenses typically increase with shorter compounding intervals. The mechanic is best illustrated with an example. Cynthia is the manager of LonelyHeartz Inc., a mobile dating app developer. She wants to obtain a $100 1-year loan to fund its development. She obtains 3 loan proposals and the proposal with the highest frequency of compounding results in the highest interest expense




INTEREST RATE SPREAD


The interest rate quoted can be expressed as the summation of 1) Real Risk-Free Rate, 2) Expected Inflation, 3) Credit Risk, and 4) Liquidity Premium.



REAL RISK-FREE


It is the required rate return that a lender charges when she lends to a counter-party with zero risks and inflation. This is the pure expression of opportunity cost, where the lender considers the trade-offs of consuming now vs. delaying consumption to earn a risk-free rate of return without other external factors.


NOMINAL RISK-FREE


Many healthy and functioning economies experience a stable level of inflation. Therefore, the required rate of return that a lender demands include a premium for expected inflation so minimally, she can keep up with inflation and would not lose purchasing power. A proxy for the nominal risk-free rate in Singapore is the MAS-issued T-bill and the SGS bonds. Both were rated AAA as of December 2019. The interest rate for each period is determined by supply-demand via the auctions.


An upward-rising yield curve is indicative of a healthy economic outlook as the short-term interest rate is low, discouraging consumers and businesses to save. Instead, it encourages them to consume and invest, stimulating aggregate demand while an inverse downward-sloping yield curve is interpreted as a possible indicator of a looming recession.


CREDIT RISK & THE 5 CS


A credit spread is expressed as the difference in yields between 2 bonds of similar maturity (eg. 5-year) but different credit quality. There G-spread measures the yield of a risk-free government treasury and a corporate bond of the same maturity. The lower the credit quality of the borrower, the wider the credit spread, resulting in a higher interest rate. As the value of a vanilla-bond is expressed as the discounted present value of its expected future cash flow, the bond will become cheaper if the credit quality deteriorates.



Credit Quality is the product of the Probability of Default [P(D)] and Loss Given Default [L|D], and these 2 factors are the quantification of the 5Cs of credit analysis.

  • Capacity to repay measures the ability to make cash repayment in the future.

  • Condition assesses the business, industry and economy and its development outlook.

  • Character evaluates the management, its risk appetite, strategies, and performance.

  • Collateral if any), its quality, and ease of liquidating it in the event of default.

  • Covenant or loan agreement, its terms and course of action if default.


Credit analysis is done by financial institutions before any loan application is approved by the credit committee for any personal, corporate or project loan.


LIQUIDITY PREMIUM


Liquidity measures the ease of converting the debt/loan into cash without incurring significant transaction costs. It is cheaper to buy and sell a publicly-floated bond as transactions are facilitated by the security exchange. They also benefit as liquidity is more transparent and observable from the daily trading volume and bid-offer spread.


Pertaining to collateralized loans, It is less expensive for a bank to liquidate a pledged collateral in when the borrower defaults, compared to going through a lengthy litigation process to recover assets when the loan is an unsecured loan. The liquidity premium is also lower when the collateral's market value is readily available like money-market instruments, instead of a property Thus, the interest rate decreases with higher liquidity.

INTEREST FROM PERSPECTIVE OF LENDERS


The level and volatility of interest rate is often determined by supply-demand forces. If you are a manager representing a company that is hungry for funding, you are the demand while investors and financial institutes supply the capital. Debt instruments are termed as fixed income from the perspective of lenders as the repayment is structured and predictable.


2 common types of lenders, a deposit-taking bank and a structured product, such as an endowment fund that pays periodic payouts and participatory bonus, are illustrated below.



For deposit-taking banks, the stream of interest income earned from borrowers is paid out to depositors. The bank earns a net spread (Interest Income - Interest Expense). Therefore, banks have a crucial role in the economy as they are responsible for sieving questionable loan applications to ensure efficient allocation of capital. The supply of capital originates from savers, whose deposit level and stickiness depend on how well the economy is performing, the interest rate, etc. If the demand exceeds supply, interest rates will be pushed up and vice versa.



A structured product typically invests in public securities, including money market securities, bonds and stocks, etc, to fund regular payouts and participatory bonuses to investors. The supply of capital originates from investors' wealth that they can afford to put aside and the investment level and stickiness depend on the general economic conditions and business cycles. High-grade fixed income instruments are perceived as defensive instruments that capital floods into when the economy takes a turn for the worse while capital moves into equity to seek capital gain when the economy recovers.


UNDERSTANDING MONETARY POLICY


As discussed, the supply and demand of debt capital significantly depend on the general economy and interest rate environment. Monetary policies are tools used by central banks to influence economic activities and inflation in the short-term. Common tools include influencing the short-term interest rates through 1) setting the policy rate which commercial banks may borrow from the central bank, and 2) open market operations which central bank buys government bonds through auctions.



The illustration describes the working of business cycles and having awareness helps managers better make inference on the interest rate, economy activity, and the demand and supply of debt capital, to help them make better financing and CAPEX calls.

FIXED-RATE AMORTIZING LOAN


Financial institutions and businesses use the Effective Interest Method to calculate the interest expense (or income) for the period and the loan amortizing table can be easily modelled using a spreadsheet.


Cynthia wants to raise $1,000 for LonelyHeartz Inc. to fund a capital project. She approaches her investment banker and suggests that the firm is comfortable with making semi-annual repayments over a period of 5 years. The investment banker estimates an interest rate of 6% p.a. based on the firm's creditworthiness and proposes an amortizing syndicated loan.


  • Payment (highlighted) = PMT(rate, nper, pv, fv, type)

  • Rate = 3% or 6% annual interest rate ÷2

  • Nper = 10 or 5 years x 2

  • Pv = -1,000 or the loan amount

  • Fv = 0 as fully amortized at end of term

  • Type = 0 or payable at end of period



FIXED-RATE PLAIN VANILLA BOND


The banker follows up by suggesting that given the firm's operating history and financial performance, it could also raise fund from the public through a vanilla-bond is. He then proposes that LonelyHeartz Inc. could opt to pay 6% coupon p.a. followed by the lump sum principal repayment at the end of Year 5. The banker proceeds to generate the spreadsheet under 2 interest rate scenarios, at 5% and 7% respectively.


SCENARIO A - INTEREST RATE AT 5%

As the value of the bond is the present value of its future cash flow, a bond that pays a coupon rate that is higher than the prevailing interest at issuance can be issued at a premium above its maturity par value as a Premium Bond. The premium is then amortized so the END balance equals the par value upon maturity.


  • BGN Balance (highlighted) = PV(rate, nper, pmt, fv, type)

  • Rate = 2.5% or 5% annual interest rate ÷2

  • Nper = 10 or 5 years x 2

  • Pmt = -30 or $60 annual coupon ÷2

  • Fv = -1,000 as face value paid at maturity

  • Type = 0 or payable at end of period


SCENARIO B - INTEREST RATE AT 7%


When a bond pays a coupon rate that is lower than the prevailing market rate at issuance, it is issued at below par value and is termed a Discount Bond. The discount is then amortized and added back to the bond so its value is equal to its par value at maturity. The bond experiences a capital gain throughout its life.


  • BGN Balance (highlighted) = PV(rate, nper, pmt, fv, type)

  • Rate = 3.5% or 7% annual interest rate ÷2

  • Nper = 10 or 5 years x 2

  • Pmt = -30 or $60 annual coupon ÷2

  • Fv = -1,000 as face value paid at maturity

  • Type = 0 or payable at end of period


However, floating a bond is a costly affair as public debt fundraising is heavily scrutinized by SGX. Listing fees charged by SGX, investment banking, credit rating, auditor, trustee fees, increased cost of performing post-listing obligations, etc, can quickly add up. But in return for the troubles, the firm enjoys access to more fund, more financial flexibility (call, put & conversion options, dual-currency, unconventional repayment structures, etc), and lower interest due to higher level of liquidity.



FLOATING RATE AND RISK MANAGEMENT


So far, we have discussed exclusively fixed-rate debts. But borrowers can also assume interest rate risks and borrow at a variable floating rate, which is calculated based on a reference rate. In Singapore, 2 commonly used reference rates are SIBOR and SOR.

SIBOR & SOR

SIBOR is the abbreviation for Singapore Inter-bank Offering Rate, which is the lowest rate banks are prepared to lend to one another in an unsecured (no collateral) basis. The SIBOR is calculated and averaged after self-submission from member banks. However, some banks misreported the LIBOR (London) rates in 2012 and rocked the credibility of self-reporting. As a result, markets are progressively moving to a more transparent and transaction-based benchmark like SOR (Swap Overnight Rate) which measures the synthetic rate of borrowing the SGD by borrowing in USD and entering into a USD/SGD swap.


The variable interest rate is typically quoted as Spread+Reference Rate, for example, 1% + 1-month SIBOR and the interest expense is paid in arrears. For example, the current interest expense paid is based on the variable interest rate on the last settlement date.


The banker proceeds to present the last fundraising option to Cynthia, which is a syndicated variable-rate amortizing loan. The floating rate will shift the interest risks to LonelyHeartz Inc., allowing the firm to benefit when the reference rate falls. However, if the reference rate rises, the business will end up paying more interest expense.


  • Payment (highlighted) = PMT(rate, nper, pv, fv, type)

  • Rate = 3% or 6% annual interest rate ÷2

  • Nper = Number of remaining payments at the time (use COUNTA)

  • Pv = -1,000 or the loan amount

  • Fv = 0 as fully amortized at end of term

  • Type = 0 or payable at end of period

RISK MANAGEMENT OF FLOATING INTEREST RATE


Some managers may prefer the predictability of a fixed interest rate. However, banks might prefer to underwrite a variable-rate loan as they might not have the risk appetite. But there are various financial instruments such as fixed-for-floating swap and interest rate caplets to help businesses hedge the interest risks. But keep in mind that hedging is expensive!


INTEREST EXPENSE FOR LEASE


Under IFRS 16, an operating lease has to be capitalized in the financial statement effectively from 1 January 2019 onwards. As a lease is a contract outlining the terms under which one party agrees to lease something owned by another party, it represents an obligation for the lessee to pay at fixed intervals and makes it similar to a financing agreement.


Cynthia signs a 4-year contract to lease a cloud hosting server for an annual fee of $10,000, payable at the beginning of each year, with an implicit interest of 5%. She has to capitalize the lease by calculating the present value and record it as an asset and liability.



By inputting rate=0.05, nper=4, pmt=-10000, fv=0, type=1, she derives $37,232 PV of the lease payments and record it as an asset and liability. On the asset side, it is amortized using the straight-line method over the lease term of 4 years.



On the liability side, it is amortized using the effective interest method. The key difference is that as lease payment is made at the beginning of the period, the interest expense is calculated at Interest Rate x ( BGN Liability - Payment) or {0.05 x ( 37,232.48 - 10,000)} for Year 1, {0.05 x ( 28,594.10 - 10,000)} for Year 2, etc.



The amortization and interest expenses are recorded in the income statement and the END liability and asset values are recorded in the balance sheet.


INTEREST INCOME


Although a non-finance business does not lend and earn interest income as part of its everyday business activity, it does earn interest income from the cash in bank and other interest-bearing securities such as short-term money securities, held-to-maturity securities (HTM), and loans made to affiliated entities, such as its parent, joint-venture or subsidiaries.


The interest income earned offsets the interest expense, lowering the cost of capital. However, it is a good corporate finance practice for the organization to focus on what it does best and not obsessively focused on its financing activities. Excessive funds held as cash and invested in other interest-bearing instruments without a clear strategic intent hurts shareholders' returns and should be better deployed in other facets on the business to generate value.


The challenge lies with the managers to strike a delicate balance between the lost opportunity cost of holding excessive cash and being prepared for an unexpected liquidity crunch. A common solution is to draw out the cash budget as part of the overall budgeting exercise to anticipate cash inflows and outflows. additionally, most firms also maintain a minimum cash balance to meet unexpected liquidity needs and take advantage of opportunities. Excess cash over the minimum balance can be temporarily invested in money market securities until they are deployed for their next use.


Some also maintain revolving line-of-credits with financial institutions for additional security as it helps to be able to tap into short-term credit to meet the challenges of an unexpected liquidity crisis, such as adverse natural event or insolvency of a key customer with significant sums of unpaid payables.

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