Interest paid on loans in Indirect Cash Flow Statement? How does it go?

[Taachan]

Hi everyone,

I have a tricky question here and I hope someone knows how to answer to it. I have a cash flow model in an indirect form. The statement has been prepared by a consultant and I would like to check that everything is in order. The questions relate to the treatment of interest paid on loans.

Questions:

1. Is interest paid any item on the cash flow statement? Since we start from operating cash flow which starts from net income, does it not mean. that interest paid should not appear on any of the three cash flow statements? In case it does not appear on them, will the rest of the questions be useless. In case they do appear, please see the questions below:

2. We can see 4 different outcomes from this in case we remove the interest paid.
A) Removed from operating cash flow: Operating cash flow and total cash flow decrease by 20, but the financial one remains the same
B) Removed from financial cash flow: Operating cash flow remains the same, but the financial gets better as well as total cash flow
C) Not removed from either one of the cash flows - stays as in the model
D) Removed from both cash flows: Operating cash flow goes down by 20, but the financial one gets better by 20. No effect on the total cash flow.

In case the model attached seems OK, what is the reason the interest has been shown like this? Any other comments?

Thank you a lot in advance & Happy New Year!

Br,

Martin

 

[Fidget]

You don't say which accounting standards you're using, but under IFRS.... If there's a cash inflow/outflow of interest then it has to be shown *somewhere* in the cash flow statement. And there is a choice for most organisations. It's often shown in operating activities because it goes through the P&L, and will be adjusted so that only the actual amount paid is in the cashflow operating activities section.

If the company wants to show it in the financing activities section, then it has to be removed completely from operating activities and then shown in financing activities, otherwise it will have been double counted in the cash flow. By the looks of it, that's what's happening in the above statement - it's been added back to operating activities, and then deducted as a cash outflow in the financing activities section.

Whichever way a company treats it, it needs to be consistent from period to period.

 

[Taachan]

Fidget,

thank you for the answer! IFRS surely works fine in this case.

"By the looks of it, that's what's happening in the above statement - it's been added back to operating activities, and then deducted as a cash outflow in the financing activities section."

---> so basically, it is ok to adjust it in operating activities (to add back, make the operating profit bigger) and then deduct it as an outflow in financing activities which will make the total sum of it zero?

Thanks in advance!

 

[Taachan]

And please note, that this is not a bookkeeping question, but more of a financial modeling related so the accounting standards do not have to be strictly evaluated, only the correct way of doing it.

Cheers!

 

[Fidget]

Fidget,

thank you for the answer! IFRS surely works fine in this case.

"By the looks of it, that's what's happening in the above statement - it's been added back to operating activities, and then deducted as a cash outflow in the financing activities section."

---> so basically, it is ok to adjust it in operating activities (to add back, make the operating profit bigger) and then deduct it as an outflow in financing activities which will make the total sum of it zero?

Thanks in advance!

Yes, it's ok to do that, but it's not making the total sum of it zero. It's just moving it from one place to another. The 20 still exists. It's already part of the 1000, so adding it back sums that part of it to zero. Then it appears in financing activities instead, so there's still an outflow of 20 for interest expense. It's just been moved from one place to another, so the total sum of it is 20.

 

[Fidget]

And please note, that this is not a bookkeeping question, but more of a financial modeling related so the accounting standards do not have to be strictly evaluated, only the correct way of doing it.

Cheers!

oh ok, although your question does specifically ask about interest expense in an indirect cash flow statement, which is something governed by accounting standards.

But anyway, there isn't really a 'correct' way of doing things when it comes to financial modelling. There's some best practice around re building a model, but what goes into it and how it is presented is usually at the discretion of whoever is building/requesting the model and what it's going to be used for.

Any I've developed or worked on contain the known constants/variables in relation to whatever it is being modelled. A load of assumptions are then applied and the model produces output predicted results based on what its inputs are. It's a bit of a playground for 'what if' scenarios.

So you could in theory, omit the interest expense, but if you omit known constants/variables, then the results are already distorted before you've applied any assumptions.

 

[Taachan]

Hi Fidget,

thank you for the answers - really helpful. I have seen many different ways of calculating / modelling so as you said, so there is no one way of doing the statement.

Anyway, do you have a source or a formula that comprehensively covers "the best way of calculating the free cash flow" starting from net profit and ending to Free Cash Flow to the Firm?

I have seen a way of doing the cash flow statement as above. In my understanding interest is not any of those items?

On the other hand I get the interest expense:

Net profit (-20 interest)
Operating Cash Flow (add back 20)
Financial Casf Flow (-20)
So the net effect will be -20.

Thanks,

Martin