Classifying Interest, Dividends and Taxes Paid

Introduction

Interest paid on a company's debt is a financing cost, so many people expect to find it in the financing section of the cash flow statement. Under US generally accepted accounting principles (GAAP) it is not there. It sits in operating activities, because it was deducted in arriving at net income, the starting point of the operating section. Dividends paid, by contrast, are financing. Income taxes are operating, even when they arise from selling a business. These placements look like details until they change a free cash flow calculation or make two companies' operating cash flows incomparable.

Each classification has a reason and a consequence. The reason is usually where the item appears in net income; the consequence is that some measures bankers build from the cash flow statement need adjusting before they mean what they are supposed to mean.

Under Accounting Standards Codification (ASC) 230, cash flows are classified by the nature of the activity, as Deloitte's roadmap on the classification of cash flows explains, but interest, dividends and taxes follow specific rules:

Cash paid for interest

The interest a company actually paid in cash during a period, disclosed as supplemental cash flow information, net of interest capitalized into assets. It can differ from interest expense because of accrued but unpaid interest, amortization of discounts and issuance costs, and payment-in-kind interest.

Two disclosures complete the picture. Companies must report the cash paid for interest, net of amounts capitalized, and the cash paid for income taxes, usually in a supplemental section at the bottom of the statement or in the notes, as covered in supplemental disclosures and non-cash transactions. McDonald's, for example, reported $1.5 billion of interest paid and $3.0 billion of income taxes paid for 2024 in its annual report.

The placement of interest has a practical consequence for free cash flow. Operating cash flow under US GAAP is already after interest paid, so operating cash flow less capital expenditure is a levered measure, the cash available to shareholders after lenders have been paid their interest, though not their principal. To reach unlevered free cash flow, the cash available to all capital providers that a discounted cash flow model uses, interest paid must be added back, after the tax shield it provided:

Consider a company with $500 million of operating cash flow, $100 million of interest paid, a 25% tax rate and $200 million of capital expenditure. Levered free cash flow is $300 million. Unlevered free cash flow adds back $75 million of after-tax interest, giving $375 million. Using the levered figure in a discounted cash flow model that also subtracts net debt would penalize the company's debt twice. The full set of definitions is in free cash flow definitions.

Unlevered free cash flow

The cash flow a business generates for all of its capital providers before any payments to lenders, usually calculated as operating cash flow plus after-tax interest paid, less capital expenditure, or built from earnings before interest and taxes (EBIT) after unlevered taxes, plus non-cash charges, less capital expenditure and the increase in working capital.

Levered free cash flow, by contrast, is what remains for shareholders after interest, and is often defined as operating cash flow less capital expenditure, sometimes also less mandatory debt repayments. Because interest paid already sits inside US GAAP operating cash flow, the levered measure is the one the cash flow statement produces most naturally, and the unlevered one is the one that requires an adjustment.

Capitalized Interest

Interest on borrowings used to build a long-lived asset is capitalized as part of its cost, so the cash paid for it is effectively part of capital expenditure and appears in investing activities. A company building factories or data centers can therefore report interest paid in operating activities well below the interest it actually incurred, with the remainder inside capital expenditure. When comparing operating cash flow or coverage ratios across companies at different stages of investment, bankers add capitalized interest back to interest paid, a point covered from the income statement side in interest and other non-operating items.

Dividends paid are financing outflows, so operating cash flow and free cash flow are measured before any dividend. That is the right basis for judging dividend capacity: free cash flow minus dividends shows what remains for debt reduction, buybacks or acquisitions. Dividends received from investments are generally operating, though under US GAAP companies distinguish returns on an equity method investment, which are operating, from returns of the investment, which are investing.

Income Taxes, Including Taxes on Disposals

Income taxes are operating even when they arise from investing or financing transactions. A company that sells a division at a large gain receives the proceeds in investing activities but pays the tax on the gain in operating activities, which can depress operating cash flow in the following period without any change in the remaining business. A banker normalizing operating cash flow for such a year should identify the tax on the disposal and treat it as non-recurring.

More Detail on Taxes Paid

Tax disclosure is also becoming more detailed. Under Accounting Standards Update (ASU) 2023-09, as Deloitte's guidance on adopting the income tax disclosure update explains, companies must disclose income taxes paid, net of refunds, split between federal, state and foreign taxes, with individual jurisdictions shown where they account for at least 5% of the total, for public companies' fiscal years starting after December 15, 2024. The new detail helps bankers estimate cash tax rates by country.

The classifications matter most when comparing companies and building cash flow measures. A short checklist covers the main adjustments:

Where an item sits on the cash flow statement never changes the net change in cash, but it changes the subtotals bankers rely on. Knowing the classification rules is what allows operating cash flow and free cash flow to be compared on the same basis across companies, years and accounting frameworks.