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Hi Chris,
Hope you are doing well. Many thanks for the lectures which are of great help to me. My question is regarding the example under the Statement of cash flow topic. Would you please advise why in CF from operating activities we add back finance costs of $400 first and then deduct it from operational profit? why don’t we classify these costs as a cash outflow from finance activities? You also mentioned that we have to check the balance sheet to whether we have interest payable or dividends to be received there. This is not quite clear to me too, would you please clarify what’s the point of it?
Thanks in advance.
Hi Egana,
I’m very well, thank you. I hope it is the same for you in Azerbaijan. Hello from Liverpool!
Everybody gets confused with the adding back of the finance costs to profit before tax as it is a bit of a crazy idea as instead of starting at PBT we could just start at profit from operations and not have to adjust PBT for finance costs.
The reason why we add it back is because we are looking at cash flow from operation but having started at PBT we need to get back to a sensible profit from operations figure. To do so requires us to add back the finance cost as this originally have been deducted from profit from operations to get to PBT.
We then deduct the cash paid within the operating activities as interest/finance costs are a mandatory payment and we want to be able to see that there is sufficient cash available from the day-to-day business to cover these cash outflows. If we don’t then we might be in trouble.
Finally, the finance cost expenses might not be the same as the interest paid due to opening/closing accruals. We therefore need to look at the SFP and the associated balances that relate to interest, i.e. interest payable, so as to adjust for these figures.
Hope that all makes sense.
Thanks
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