Short answer
Interest is the cost of using borrowed money during the period. Under accrual accounting, costs incurred to run the business in a period are expenses of that period, so interest belongs on the income statement. Repaying the principal isn't a cost; it just returns money you borrowed, so it only affects the balance sheet and the cash flow statement.
Interest vs. principal
Say a company borrows $1,000 at 8% for five years.
- The $1,000 is a liability. When the company receives it, cash and debt both rise by $1,000. No profit or loss: the company is no richer, it just owes money.
- The $80 a year of interest is the price of renting that money. It's a real cost of doing business that period, so it's an expense.
- When the company repays the $1,000, cash and debt both fall. Again, no profit or loss.
Where interest sits on the income statement
Interest expense appears below operating income (EBIT), because it reflects how the company is financed, not how well it operates. That's why analysts use EBIT and EBITDA to compare businesses with different amounts of debt: those metrics exclude financing costs.
The interest tax shield
In most tax systems, interest is tax-deductible, subject to limits that vary by country. With the $80 of interest and a 25% tax rate:
- Pre-tax income falls by $80
- Taxes fall by $80 × 25% = $20
- Net income falls by only $60
That $20 saving is the interest tax shield, one reason private equity firms use debt in leveraged buyouts, and why the cost of debt in WACC is shown after tax: Kd × (1 − t).
How it flows through the three statements
| Statement | Effect of $80 interest (25% tax) |
|---|---|
| Income statement | Interest expense +$80, taxes −$20, net income −$60 |
| Cash flow statement | Net income −$60; cash paid for interest is already in net income, so cash falls $60 |
| Balance sheet | Cash −$60; retained earnings −$60 |
Under US GAAP, interest paid is classified as an operating cash flow (it flows through net income). IFRS lets companies choose operating or financing. Debt principal repayments are always financing cash flows.
A few nuances
- Capitalized interest: interest on money borrowed to build a long-term asset, like a new factory, can be added to the asset's cost during construction instead of expensed right away. It's then depreciated over time.
- Accrued interest: if interest is owed but not yet paid at period-end, it's still expensed, and a liability for accrued interest goes on the balance sheet.
- Circularity in models: interest depends on debt, and debt paydown depends on cash after interest. Modelers either use average balances with iterative calculation turned on, or opening balances to avoid the loop, as our free LBO template does.
Build a debt schedule yourself
The free “Debt schedule and cash sweep” lesson covers interest, amortization and paydown.