Effective Interest Rate (%)The effective interest rate is calculated by dividing average total debt outstanding by total interest expenses (including capitalised interest).
We are concerned when a company’s effective interest rate is too high or too low relative to the central bank policy rate (or average corporate borrowing costs) of their country of domicile.
- High effective interest rate: If the effective interest rate is too high relative to the central bank policy rate, it could suggest that creditor banks regard the company as being a poor credit risk and, therefore, charge a higher interest rate. A high effective interest rate can also be an indication that a company is window dressing by selling short term assets in order to reduce debt just prior to the reporting period. In short, the company is attempting to flatter its financial position. The effective interest rate is higher than expected because the average debt level throughout the reporting period is actually far higher than disclosed at the period-end. For example, during 2012, Noble Group recorded an effective interest rate of 7.1% for a company that was of investment grade, and should have been paying half that amount. Another way to spot companies that might be window dressing is to monitor the relationship between debt repayment and short term debt at the beginning of the financial period. An unusually high level of debt repayment relative to short term debt suggests that a company is window dressing. For more information, please read NOBLE GROUP: Turning Tax Losses into Accounting Profits (1 Apr 2015).
- Low effective interest rate: If a company’s effective interest rate is too low relative to the central bank policy rate, it could suggest that the company has opted to source nominally cheaper foreign funding which creates as asset liability mismatch. To confirm this, investors should read the note on debt within the financial statements.It could also suggest that the company is overly reliant on short term debt.
Our accounting screen is set to trigger a red flag when the effective interest rate spread over the central bank policy rate is below the 20th percentile (i.e. it is very low) or exceeds the 80th percentile (i.e. it is very high) relative to country domicile peers, and/or when there is an abnormally large increase relative to the normal rate of change amongst country peers over one and three years. This latter red flag is triggered when the increase in the effective interest rate exceeds the 80th percentile relative to the change experienced by country peers between 2010 and 2015..