Interest Expense is the cost of borrowing money. When a company borrows money, it is paid back with Interest. The amount of Interest that is paid back is the Interest Expense.
Operating Income is the difference between Total Revenue and Expenses. It is the profit the company makes after all their expenses.
In the consumer products industry. A ratio of Interest Expense to Operating Income of less than 15% is ideal. In other industries besides consumer products, the company's Interest Expense to Operating Income ratio should be less than its competitors.
As a rule, in any given industry, the company with the lowest Interest Expense to Operating Income Ratio is most likely the one that has a Durable Competitive Advantage. A low Interest Expense to Operating Income Ratio means that the company does not need to borrow a lot of money to stay in business. The company makes enough money so they do not need to take out a loan.
A low Interest Expense to Operating Income Ratio is also an indication of good credit, valuable assets, and plenty of cash on hand. It is an indication that the company is financially fit and has never missed a payment on their debt. The lower the better.
Equations
For companies in the consumer products industry:
For companies in other industries:
Example 1
In the year 2010, Coca-Cola had $733 Million in Interest Expense and $13.741 Billion in Operating Income.
Date: Year 2010
Company: Coca-Cola
Interest Expense: $733 Million = $0.733 Billion
Operating Income: $13.741 Billion
Coca-Cola's Interest Expense to Operating Income Ratio comes in at 5.3% which is really low.
Example 2
In the year 2010, American Airlines has $770 Million in Interest Expense and only $308 Million in Operating Income.
Date: Year 2010
Company: American Airlines
Interest Expense: $770 Million
Operating Income: $308 Million
American Airlines has gone in and out of bankruptcy over and over again throughout its history. At an Interest Expense to Operating Income Ratio of 250%, they are just paying way too much on Interest Expense compare to what they are earning.
Example 3
Let's compare IBM's Interest Expense to Operating Income Ratio to its competitors, Hewlett Packard and Oracle.
Year: 2011
Company: IBM
Interest Expense: $411 Million = $0.411 Billion
Operating Income: $21.003 Billion
Year: 2011
Company: Hewlett Packard
Interest Expense: $294 Million = $0.294 Billion
Operating Income: $9.677 Billion
Year: 2011
Company: Oracle
Interest Expense: $782 Million = $0.782 Billion
Operating Income: $12.033 Billion
Out of the three companies, IBM has the lowest Interest Expense to Operating Income Ratio coming in at 2.0%.
| IBM | Hewlett Packard | Oracle | |
Interest Expense to Operating Income Ratio | 2.0% | 3.0% | 6.5% |