Which of the following must be added to operating income when calculating free cash flow?

• A. Accounts receivable
• B. Depreciation expense
• C. Net sales
• D. Dividends paid

Answer: (B)

Verified step by step guidance

1. Understand the concept of Free Cash Flow (FCF): Free Cash Flow represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. It is calculated using operating income and adjustments for non-cash expenses, changes in working capital, and capital expenditures.
2. Identify the components of Free Cash Flow: To calculate FCF, you start with operating income (or net income) and adjust for non-cash expenses like depreciation and amortization, changes in working capital (e.g., accounts receivable, inventory, accounts payable), and subtract capital expenditures.
3. Recognize the role of depreciation expense: Depreciation is a non-cash expense that reduces operating income but does not involve an actual cash outflow. Therefore, it must be added back to operating income when calculating Free Cash Flow.
4. Evaluate the other options: Accounts receivable represents a change in working capital and may need to be adjusted depending on whether it increased or decreased. Net sales and dividends paid are not directly added to operating income for Free Cash Flow calculations. Dividends paid are a financing activity, not an operating activity.
5. Conclude the adjustment: When calculating Free Cash Flow, depreciation expense must be added back to operating income because it is a non-cash expense that affects reported income but does not impact cash flow.