Question

Part 1) Please indicate which section of the statement of cash flows should contain each of the following items, and whether each item would result in an inflow or outflow of cash. The sections are Operating, Investing, and Financing. (30 points) (a) Increase in accounts receivable (b) Purchase of a factory with cash (c) Depreciation of a building (d) Retirement of bonds with cash (e) Receipt of cash dividends Part 2) Explain how to calculate free cash flow and the importance of free cash flow to investors.

Answer 1

ANSWER:-

a). Increase in accounts receivable will come under the operating a ticket section because a count receivable includes goods and services provided on a credit basis which are operational activities of an organization. Hence it will be operating activity. Further increase in accounts receivable will lead to outflow of cash.

b) . Purchase of factory with cash = it will come under investing activity. Further purchasing includes payment of Cash, thus, it will lead to outflow of cash.

c) .Depreciation of a building = we know that depreciation is an operating expenses , thus it will come under activity section. Further since depreciation is a non Cash item and is already deducted while calculating profit and we calculate Cash flow flow using profit figure, thus it will amount to inflow of cash.

d). Retirement of bonds with cash = bonds arare financing arrangement and their retirement involves payment to bondholders cash, thus retirement of bonds will come under financing activities and will amount to outflow of cash.

e). Receipt of cash dividend = dividend generally comes from any investment made by us. Thus, receipt of dividend would come under investing activities and it will lead to inflow of cash.

Part 2. Free cash flow is the cash available to all the investors including common stock, preferred stock, lendrd etc. And will be calculate as follows :-

Cash flow from operating activities + interest expenses - tax shield on interest exp. - capital expenditure = free Cash flow

Or EBIT x(1-tax rate)+ non Cash exp. - changes in working capital - capital expenditure.

Free Cash flow is very important for investors because of the following reasons:-

1 . It shows that company have ability to payback the int. And principal amount of loan, stockholders dividend, thus they are assured of their return.

2. It is measure of financial well being of a company. A company with good amount of free Cash flow is considered financially healthy company.

3 . Most importantly a company with good amount of free Cash flow would be able to grab the opportunities with both hands as and when they will arise which ultimately leads to growth of the company and growth of their investment.