I think most people would agree that interest expense is an important part of a company’s income statement. The cost of servicing debt is often a material expense, particularly for highly-geared private equity companies. Many important lines are now opaque but the finance line is worse; it is both opaque and volatile. This volatility then flows down to pre-tax profit and earnings per share, undermining the utility of these metrics.
Like many poor standards, the road to frustration was paved with good intentions. I remember Sir David Tweedie, former International Accounting Standards Board chairman, saying that his ideal financial instrument standard would have two paragraphs: 1, mark all instruments to market at the end of every period and take the gain or loss through the income statement; 2, re-read paragraph 1.
What we have today is effectively a revised paragraph 2, which says ‘make it as difficult as possible for users to understand what is going through the P&L, and where it is being charged. And make sure that the accompanying note is so long and complex that no one will try and read it’.
There is one really important item buried inside financial expenses: the cost of servicing debt. The ability of a company to keep its lenders happy is crucially important and yet interest cover is usually impossible to calculate without additional voluntary disclosure.
Forcing companies to mark financial instruments to market is in many ways a good idea. It reflects reality (on that day anyway), it removes subjectivity and it reduces the potential for financial engineering.
When I started out 25 years ago, I could usually estimate financial expense with some confidence. Today, it has become so difficult that I have largely given up
The problem, though, is that the gain or loss is notional. The ‘real’ gain, when the instrument matures or is sold, can be very different. Lumping these notional gains with real-world costs is both undesirable and distorting. Many derivatives are taken out to hedge expected future foreign currency cashflows, which reduces real-world uncertainty but increases short-term reporting volatility.
There are other distortions, too. Pension interest expense may not be volatile but it is very different from debt service expense. It is the notional carrying cost of an estimated multi-decade liability with no implications for cashflow.
The finance line often includes the amortisation (or writing off) of arrangement fees and the cost of early debt repayment. These are all very different in nature to paying interest to lenders.
No reflection of reality
When I started out as an analyst about 25 years ago, I could usually estimate financial expense with some confidence. I knew the effective debt rate, I could forecast the cashflow and so the actual interest expense was seldom a surprise. Today, it has become so difficult to forecast this line that I have largely given up.
One of the reasons that users focus more on EBIT and EBITDA is that financial items no longer reflect operating reality
It is not at all unusual to find that reported financial items are twice or half what I expected. The culprit is usually mark-to-market of derivatives, but even after the numbers are published, you still can’t work out what actually happened. One of the reasons that users focus more on EBIT and EBITDA is that financial items no longer reflect operating reality.
We live in a world with low interest rates and, not coincidentally, more and more private equity companies with very high debt burdens. Many of the recent business failures have been more about debt levels than underlying trading. Understanding real interest expense has never been more important to users and current disclosure is largely useless.
As with discontinued operations, companies that care about their investors should tell them what is really going on inside financial expenses.