Purpose: To help you understand the importance of cash flows in the operation of a small business. You just received your year-end financial statements from your accountant. Although receiving the year-end financial package is important every year for your financing institutions and your investors, it is especially important this year because of the potential investment opportunity that just became available to you. Yesterday you got a telephone call from one of your competitors with whom you have been discussing the possibility of a merger. The gist of the conversation was that the board of directors wanted to sell outright to you instead of merging.
You’re pretty happy about that except for the fact that it could create some potential cash flow problems. The other company wants $1,000,000 cash and it wants to do it soon or the deal is off. You’ve got that amount of cash and cash equivalents available right now, but you know there are some cash commitments coming up soon for capital expenditures and dividend payments. You decide to call one of your financial investors. He or she suggests that you calculate free cash flow from the end of the year to determine if that amount of cash is available to complete the deal.
You look at your cash flow statement from the financial statements and see that cash flows from operations was $1,725,000 and you expect that same amount for this year. From the capital budget, anticipated capital expenditures in the short term are $550,000. And from the board of director’s minutes of the last meeting, the cash dividend approved for payout next month is $275,000.
Requirement
Define free cash flow and calculate it based on the information previously provided. With your understanding of free cash flow, is this new investment something that this company should pursue?