The purpose of computing the operating cash flow by subtracting the operating outflows from the inflows is meant to determine the amount that will be distributed to the creditors and shareholders. The creditors and shareholders have contributed equal amounts to finance Boomwichers NV’s investment project. The free cash flow is used to settle the debt obligations and provide returns to the shareholders. In year n, the flows to creditors and shareholders are negative since they are outflows. However, for year n+1 to year n+5, the flows to both parties are positive since they are inflows to them. When the entity obtains debt financing, it has to pay interest as the cost of acquiring the debt. For this reason, the interest paid by Boomwichers NV has been calculated as 5% of €100 million, which is €5 million. In the final year, the interest will be paid in addition to the principal amount of €100. The payments to the shareholders will equal the difference between free cash flows and payments made to the creditors.
The computations of the free cash flows and cash allocations to creditors and shareholders allow the entity to meet its financial strategy of obtaining funding from external sources and using such finances wisely to generate profits. In this case, the entity can satisfy the return-based needs of external parties such as creditors and shareholders. Creditors and shareholders provide cash resources to the company for investment and operating purposes (Brigham & Houston, 2021) . The entity must use the cash resources wisely to generate sufficient cash flow to repay the obligations and earn a profit. The free cash flow computations enable the entity to allocate the cash resources wisely, and, as a result, both the creditors and shareholders will be satisfied after their financial needs are met.
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Chapter 3 Exercise Analysis
The calculations show the distinction between the by-function and by-nature income statements. In the by-nature income statement, the computations show the changes in the inventories of the finished products in addition to costs such as taxes, depreciation, and amortization (Vernimmen et al., 2018) . The computations show the total amount spent by Starjo AB in its production process. The statement provides a highly detailed breakdown of the costs. The by-function income statement depicts the cost of sales, personnel expenses, and premises amortization costs. The statement offers a short breakdown of the costs incurred by the entity. The computations show how simple it is to derive the EBIT by subtracting the cost of sales from the turnover. The computations also show the effect of various transactions, including paying salaries, paying loans, and selling assets on Starjo AB’s EBITDA and net income.
The computations assist the entity’s strategy by allowing it to identify the cost allocation and the amount of operating income it generates. In this case, the entity can know which cost component is the highest, and, for this reason, the firm can formulate cost management strategies to reduce costs. The reduction in costs is beneficial to the entity since it contributes to higher operating income and net earnings (Fred, 2013). An increase in the net profits is a sign that the entity’s financial performance and condition are excellent. The computations of the finished goods and its associated costs in the by-nature income statement allows Starjo AB’s manufacturing department to determine whether its direct costs related to labor and overheads are high. They also allow the purchasing department to determine whether it needs to change its supplier due to high costs. Based on the computations, Starjo AB can make changes by reducing its manufacturing costs to increase its EBITDA and net profits. Resultantly, the entity will be able to improve its financial performance.
References
Brigham, E. F., & Houston, J. F. (2021). Fundamentals of financial management . Cengage Learning.
Fred, P. (2013). Fundamentals of financial accounting . McGraw-Hill Education.
Vernimmen, P., Quiry, P., Dallocchio, M., Le, F. Y., & Salvi, A. (2018). Corporate finance: Theory and practice . Chichester, West Sussex, United Kingdom, Wiley.
