I have a few questions about cash flows and would appreciate your answers: 1. Why does U.S. GAAP consider interest expense as operating activity, but not financing activity? 2. When we calculate CF from operating activities with indirect method, we add noncash items, nonoperating losses, increase in deferred income tax liability and changes in working capital resulting from accruing higher expenses than cash payments, or lower revenues than cash recipts back to the net income. The definition of free cash flow is the excess of operating cash flow over capital expenditures. The Free Cash Flow to the Firm (FCFF) formula is as follows: FCFF=NI+NCC+Int(1-Tax rate)-FCInv-WCInv I do not understand why only NCC (Noncash charges) are added back to NI to calculate operating cash flow. Why are the other items mentioned above omitted? Thank you!
mino, you’ve raised some interesting questions. I’ll take a stab at it and hope that Super I, TMurf or any of our other resident FSA gurus can correct me where I’m mistaken, particularly w/r/t/ your second question. FIRST QUESTION: Let’s go directly to the source on this one. Below are excerpts from SFAS 95. www.fasb.org/pdf/fas95.pdf (p.28-29 of the PDF) “Interest Paid and Received 88. The Exposure Draft required interest paid and interest and dividends received to be classified as cash flows from operating activities. That classification is consistent with the view that, in general, cash flows from operating activities should reflect the cash effects of transactions and other events that enter into the determination of net income. 89. Some respondents to the Exposure Draft favored classifying interest paid as a cash outflow for financing activities and interest and dividends received as cash inflows from investing activities. Those respondents generally said that interest paid, like dividends paid, is a direct consequence of a financing decision and thus should be classified as a cash outflow for financing activities. That is, both interest and dividends are returns on the capital provided by creditors and investors, and both should be classified with returns of those amounts because the distinction between returns of and returns on investment is largely irrelevant in the context of cash flows. Respondents made similar comments for interest and dividends received. 90. The Board considered those views and, as mentioned in paragraph 86, noted that a reasonable case can be made for alternative classifications of certain items. However, the Board also noted that virtually all enterprises classify interest received and paid as operating cash flows under Opinion 19. In particular, interest received and paid were commonly considered to be operating cash flows of banks and other financial institutions. In addition, the Board perceived widespread support for the notion that operating cash flows should, insofar as possible, include items whose effects are included in determining net income to facilitate an understanding of the reasons for differences between net income and net cash flow from operating activities and net income. The Board therefore was not convinced that changing the prevalent practice in classifying interest received and paid would necessarily result in a more meaningful presentation of cash flows. This Statement does, however, require that the amount of interest paid during a period (net of amounts capitalized) be disclosed, which will permit users of financial statements who wish to consider interest paid as a financing cash outflow to do so.” SECOND QUESTION: Here I’m uncertain, but I think the following considerations may be valid: 1) The calculation methodology for CFO is prescribed by GAAP. Conversely, there are numerous definitions of free cash flow (FCF). 2) Our interest in FCF relates to its use in company- and equity valuation, whereas we don’t use CFO directly in this manner. There’s likely items required by GAAP to be in CFO that don’t hold meaning for us from a valuation standpoint. 3) Non-cash charges (NCC) encompasses more items than I think you’re acknowledging. 2008 CFA LII Volume IV, p.361 lists some of the common items included in NCC and how they adjust NI to arrive at FCFF: “- Depreciation (added back) - Amortization of intangibles (added back) - Restructuring charges (epense: added back) - Restructuring charges (income resulting from reversal: subtracted) - Losses (added back) - Gains (subtracted) - Amortization of long-term bond discounts (added back) - Amortization of long-term bond premiums (subtracted) - Deferred taxes (added back but warrants special attention)” Anyway, I’m curious to see what others have to say.
And of course international standards (IAS 7) allow the classification of interest expense as either an operating or financing cashflow. Ultimately, it’s all just convention.
Thank you very much for your detailed explanation, hiredguns1… I have two more questions : - How are these two formulas equal? FCFF=NI+NCC+Int(1-Tax rate)-FCInv-WCInv FCFF=CFO+Int(1-Tax rate)-FCInv - Why do we add back increase in income tax payable and interest payable back to net income while calculating CFO? Are they also classified as noncash items? I think I am a little confused with cash flow calculations 
mino, a few comments: 1) those two FCFF formulas are equal because the “CFO” item in the 2nd formula already reflects the NCC and WCInv items from the first equation, so all that’s left to accomplish is adding back the tax shield on the interest expense and netting out fixed capital investment. 2) In the indirect method, you’re adjusting NI for non-cash charges and changes in the working capital accounts (like the two you’ve listed). An increase in a current liability account is a source of cash, while a decrease in a current liability account is a use of cash. Similarly, an increase in a current asset is a use of cash, while a decrease in a current asset account is a source of cash. How does this make sense? Two examples: 1) Let’s assume inventory (a current asset) increases between balance sheet periods, so how’d it increase? Well, we had to buy more inventory, using cash. 2) Now let’s assume accounts payable (a current liability) decreases between balance sheet periods, how’d that liability decrease? We had to use cash to pay off our suppliers. You get the picture… Finally, a friendly piece of advice: FCFF and FCFE are LII material, just ignore all of that for now and focus on mastering the calculation of CFO, which is LI material. Take a break, revisit the material, and it’ll make sense in due time. Good luck!
Thank you very much for your answer and advice… I see that NCC reflects nonoperating losses/gains also. The book classifies the items to be added back to net income seperately as NCC and nonoperating losses and then adds only NCC back to the net income. That was the thing that really confused me… Anyway, now I understand it better…