Interest capitalisation: into the debt principal or into the cost of an asset

Interest capitalisation means giving up a cash payment in favour of a larger base. In corporate finance the term has two different addresses. On the liability side, accrued interest is added to the principal amount of the debt, and the next period is calculated on the enlarged principal. On the asset side, interest on a loan taken out to create a long-lived asset is included in its initial cost and therefore does not reach the expenses of the current period. The mechanisms are different, the financial statements react differently, and the two must not be confused. Let us clear away a third sound-alike straight away: a company's market capitalisation has nothing to do with interest. It is the price of all the shares, and it has its own analysis with free-float and the term market capitalisation.

Interest into the debt principal: a base that grows by itself

An ordinary loan works like this: interest accrues and is paid, and the principal stays where it is. With capitalisation the interest accrues but no money leaves, and the creditor's claim grows. In the next period the rate is applied to an amount that already includes past interest. This is compound interest, only working against the borrower.

This structure is found in mezzanine financing and PIK tranches, in restructurings where the creditor grants a respite on cash flow, and in agreements with a grace period for the duration of construction. In economic terms it is not a discount but a deferral: the borrower buys cash today at the price of a larger repayment later.

The speed at which the base grows is determined not only by the rate, but also by how often the accrual is added to the principal and by which rule the days of the period are counted. Here it is worth looking at the day count basis: one and the same rate gives a different result under a different basis and a different frequency. The term day count basis explains why the discrepancy arises.

Capitalisation into the cost of an asset: an expense that is not in the period

The second meaning is an accounting one. When a company builds an asset that takes a long time to get ready for use, the borrowing costs attributable to that asset may be included in its cost. The Russian PBU on accounting for expenses on loans and credits and the international standard on borrowing costs agree in their logic: interest for the period of creation is part of the price of creation. The standards each have their own details on the threshold, the list of qualifying assets and the cessation of capitalisation, and in a note to the financial statements the issuer is obliged to disclose both the amount and the capitalisation rate applied. The details of the mechanism are in the term cost capitalisation and in the piece on cost capitalisation.

What this does to the reported figures:

• profit for the period is higher, because part of the interest went not into expenses but into the asset;
• EBITDA is higher by the same route, and the operating margin looks better than that of a competitor with the same loans and the same construction project but without capitalisation;
• assets and future depreciation are larger: the expense has not disappeared, it has been deferred and spread out;
• in the cash flow statement, interest that has been paid and capitalised is often shown in the investing section together with the spending on the asset, so the operating cash flow looks cleaner. The rules allow different classifications, so companies cannot be compared on one line without checking it against the notes.

Why this matters for covenants and multiples

Interest coverage is the ratio that capitalisation distorts most of all. If the interest has gone into the cost of an asset or into the debt principal, it may be missing from the denominator, and the burden looks lighter than it really is. Rating practice answers this directly: capitalised interest is added back to interest expense, and coverage is calculated on the full accrued amount. What exactly the covenant counts, interest paid or interest accrued, is written in the issue documentation, and the wording there matters more than the general rule. The term interest coverage gives a working definition.

It is the same story with multiples: capitalisation raises the denominator of EV/EBITDA without changing the debt for the better, which is why the security looks cheaper. Why the numerator holds the price of the whole business rather than of the shares is explained in the piece on multiples.

How to check it by hand

The procedure is simple. Step 1: find the note on borrowing costs in the issuer's financial statements; it contains the amount of interest capitalised for the period. Step 2: reconcile the interest expense in the income statement with the interest accrued on the loan portfolio; the gap is precisely the capitalised part. Step 3: recalculate coverage and the debt burden with the amount added back and see whether the picture changes qualitatively.

On the investor's side, the direct counterpart of capitalisation is reinvestment. A coupon on a bond or on an OFZ arrives in cash and is not added to the principal by itself: the effect of compound interest arises only if you use it to buy new securities. With a deposit that capitalises interest, the bank does the adding. The difference is substantial, and yield to maturity by default assumes a reinvestment that may not happen. For an individual, accrued income forms the tax base under the rules of 13%, even when the money has stayed inside the instrument.

The remaining definitions are in the site's glossary.