Question

In: Finance

In most cases a paragraph or so for each question will be sufficient. For problems, show...

In most cases a paragraph or so for each question will be sufficient. For problems, show your work such as calculator inputs and outputs for full credit.

  1. How do we determine a firm’s cash flows? What are the equations, and where do we find the information?

Solutions

Expert Solution

A firm's cash flows can be categorised as operating , investing and financing cash flows.
Measurement of cash generated from the operating & investing activities , utilising inflows(borrowing of debt & new issue of shares) & outflows (repayment of debt & retirement of shares )of the financing activities   , helps the firm to know the efficiency in cash management.
Operating cash flows can be found out by using the Income statement & balance sheet--
We can calculate directly, by taking collections from customers , subtracting therefrom , payments to vendors, employees , insurance & taxes --ie.   direct method-- by which cash payments towards purchases & cash receipts from sales , in co-ordination with the beginning & ending balances of accounts such as accounts payable, inventory & accounts receivable --can be identified.All other cash payments like wages & salaries of employees, & income taxes are taken from the income statement.
On the other-hand,by employing the indirect method--- we start from net income from the income statement & add all non-cash items of expenses such as depreciation and loss on sale of asset or subtract all non-cash items of income like gain on sale of assets/investments.In addition, changes to working capital items(balance sheet)are added /subtracted as the case may be ---and net operating cash flow generated /used is determined.This is called OCF, in short.
From OCF capital expenditure towards purchase of assets is subtracted to get the firm's free cash flows available to shareholders & debt-holders--- this can be found out by comparing the beginning & ending gross assets balances in the balance sheet.
so, this free cash flow can be expressed in the form of the following equation:
FCF=EBIT*(1-Tax rate)+Depreciation-Changes to net working capital-Capital Expenditure
where
EBIT*(1-Tax rate)+Depreciation-Changes to net working capital= Operating Cash flow or OCF
EBIT=Operating income
we leave out interest (that is why we consider EBIT) so as to find the total cash available to both shareholders & debt-holders.
We can find all the informations referred above, from cash flow statement,income statement & balance sheet of companies.

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