CHAPTER 7 CASH FLOW ANALYSIS

REVIEW QUESTIONS AND PROBLEMS

Questions

1. Explain how depreciation generates actual cash flows for the company?

Depreciation is a non cash expense and it will reduce the taxable income of
the business. Reduction in taxable income will decrease the tax liability of the business.
Present of depreciation will lower the tax expenses and reduce cash outflow for tax
expenses. It is known as depreciation tax shield and it would provide cash inflow by
decreasing cash out flow for tax payments. Depreciation generates actual cash flows for
the company by providing a tax cover against the reported estimate of income.

2. What is the difference between net cash flow from operating activities and
net cash flow from investing activities and net cash flow from financing
activities?

In the statement of cash flow, the cash generating activities are classified as
operating activities, financing activities and investing activities. Net cash from operating
activities is the cash generate by the business from its basic business operations or
revenue generating activity. It includes cash generating activities like sales, purchases,
payment of expenses, payment of taxes etc.
Cash from investing activities comes from the activities of business related to
making investments or capital expenditures. They specially relate to the non- current
assets or fixed assets section in the balance sheet. Investing activities include purchase
of assets, sale of assets etc.
Cash from financing activities relates to the cash inflow and outflow from long
term financing by the business. They include issue of shares redemption of loans,
bonds and debentures, dividend payment, purchase of treasury stock etc.

3. What are the free cash flows for a firm? What does it mean when a firm’s
free cash flow is negative?
 Free cash flows represents the cash flow from a business after considering
depreciation, working capital, taxes and capital expenditures. It shows the balance in
cash after meeting all its expenses. It is useful in assessing the value of a firm. Free
cash flow can be positive and negative. If it is positive, it indicates that the firm has
made enough revenue to meet all its expenses including capital expenditures. A
negative free cash flow means that the revenue generated by the firm is insufficient to
meet all the expenses and investment requirements.