Reading: Extensions and FAQ

Another important question is how to deal with interest income in the cash flow statement. 

 

The answer is as follows:

• Interest earned on operating cash is part of the firm's operating activity. We include this interest income (and the associated higher taxt burden) when computing the firm's operating profit (NOPLAT).
• In contrast, interest earned on excess cash (or other excess assets) is unrelated to the firm's operating activity. We ignore this interest income (and the associated higher taxt burden) when estimating the firm's operating, free, and residual cash flow. We treat the (after-tax) interest income on excess cash as a cash flow from equity financing. That is, we add this amount to the residual cash flow to derive the change in excess cash.

 

Let's illustrate these considerations with a simplified example.

 

Suppose a firm has the following income statement (accounting version):

 

EBIT	1'000
- Interest expenses	300
+ Interest income	700
Earnings before taxes	1'400
- Taxes (20%)	280
Net income	1'120

 

Let's assume that 100 of the interest income comes from operating cash and that the remaining 600 are earned on excess cash.

Following the logic from above, we add the interest income on operating cash (100) to the firm's EBIT (1'000) to get the firm's operating profit before taxes (1'100):

 

Operating profit before taxes = EBIT + Interest income on operating cash = 1'000 + 100 = 1'100.

 

Given a tax rate of 20%, the taxes associated with the firm's operating profitability are 220:

 

Adjusted taxes = Operating profit before taxes × Tax rate = 1'100 × 0.2 = 220.

 

Hence, the firm's NOPLAT is 880:

 

NOPLAT = Operating profit before taxes - Adjusted taxes = 1'100 - 220 = 880.

 

Note that we get the same result when adjusting the firm's net income (1'120) by:

• Adding the after-tax interest expenses of 300 × (1 - 0.2) = 240
• Subtracting the after-tax interest income on Excess cash of  600 × (1 - 0.2) = 480.

 

NOPLAT = 1'120 + 240 - 280 = 880.

  

The table below shows the complete cash flow statement for a firm with interest income. 

 

Cash flow statement	Year X
Net income	1'000
+ After-tax interest expenses	240
- After-tax interest income on Excess cash	480
NOPLAT	760
+ Depreciation	…
- Increase in Operating assets	…
+ Increase in Operating liabilities	…
Operating cash flow	…
- Net investments	…
Free cash flow	…
- After-tax interest expenses	240
- Repayment of debt	…
Residual cash flow	…
+ Equity offerings	…
+ After-tax interest income on Excess cash	480
- Dividends	…
Change in Excess cash	…

 

As before, we subtract after-tax interest expenses from the free cash flow because these interest expenses constitute a debt financing cash flow. Following the logic that Excess cash "belongs" to the shareholders, we treat the income the firm earns on that excess cash as a cash flow from equity financing. Hence, we add the after-tax interest income on excess cash to the residual cash flow to find the change in excess cash.