Question

Interest payment due to debt can be burdensome to businesses. If interest payment is too high, it will have a negative impact on earnings before tax. However, interest payment can also reduce tax obligation of a company. Using an example, explain how interest payment on short-term and long-term debt can reduce the amount of taxable income of a company.

Answer 1

Interest Payments on both long term and short term debt reduces the amount of taxable income of the company. As company chooses to take short/long term debt the fixed interest obligation of company increases. The amount of interest expense has a direct impact on profitability, especially for companies with a huge debt load. Heavily Debt financed companies have a hard time serving their debt loads during economic downturns. Investors and analysts also pay close attention to solvency ratios such as debt to equity and interest coverage in respect of these companies.

Short tem debt includes the short term or current liabilities like bank overdraft, accounts payable, bills payable ,etc. any interest to be paid on bank overdraft or short term loans is directly deducted from Gross profit to get earnings before taxes.

Long term loans are bank loans or debentures issued for the purpose of debt financing and these are also deducted from profits to get earnings before taxes and these loans have tenure of more than 12-months.

for example: suppose a company is having value of $1000 million . Company has EBIT as $80million and rate payable on debt is 10% interest.

Case 1: Equity-100%, Debt-0%

Case 2: Equity-75 % , Debt-25%

Case 3: Equity-50%, Debt-50%

Particulars	Debt-0%	Debt-25%	Debt-50%
Equity	1000	750	500
Debt	0	250	500
EBIT	80	80	80
less:interest paid	0	25	50
EBT	80	55	30
Less:Tax(50%)	40	27.5	15
EAT	40	27.5	15

So from above example it is clear that as the amount of debt increases the burden of fixed interest payable also increases and it inturns reduces the amount of taxable income of the company nd will have negative impact on earnings before tax.