# Cash Flow Questions

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!

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…