Companies are required under numerous federal and state laws to provide investors with financial statements on a regular basis. In addition, lenders often require financial statements when a company applies for a loan. A company may have capitalized interest that has accrued during the period covered by a financial statement. Whether that interest is added back to the cash flow statement will depend on the method the company uses to determine available cash flow.
A business often borrows funds to construct a long-term asset such as a building. The interest paid on the borrowed funds is capitalized interest that is included in the cost of of the asset. By including the interest in the long-term cost of the asset, the interest can be included when depreciating the asset. The amount of interest that may be considered capitalized interest is calculated by the date the asset becomes substantially ready for use.
Cash flow is one of many indicators of a company's financial health and stability. At its most basic, it refers to the cash a company has on hand at any given time or during a specific time frame. While net income is one benchmark of a company's financial health, the cash flow statement provides additional information that creates a better understanding of exactly how much cash is coming in and going out of a business.
Adding Back Capitalized Interest
When a company prepares its net income statement, interest paid is subtracted as a debit. For example, if a company had gross income of one million dollars and paid $100,000 in interest during the statement period, then $100,000 would be subtracted as a debit from the gross income, leaving a net income of $900,000. Assume that the company had another $200,000 in expenses during the statement period. The company then had a net income of $600,000. A cash flow statement may add back that interest if it was capitalized interest, for a cash flow statement showing $700,000 in available cash.
There is no universally accepted method of calculating cash flow. For many years, cash flow was commonly calculated by taking the net income and adding back depreciation, including capitalized interest. Some argue that cash flow should include earnings before interest, taxes, depreciation and amortization (EBITDA). This approach is favored by creditors, as it generally results in a larger amount of available funds to pay principal and interest payments. Others use the free cash flow (FCF) method to arrive at cash flow. Under this method, capital expenditures, including capitalized interest, would not be deducted from the available cash. Numerous variations exist, making the significance of a cash flow statement questionable.