Under the perpetual and periodic inventory systems, what effect will a decrease in inventory have on free cash flows, assuming all other factors remain constant?

• A. It will have no effect on free cash flows.
• B. It will increase free cash flows because less cash is tied up in inventory.
• C. It will decrease free cash flows because inventory purchases increase.
• D. It will decrease free cash flows because cost of goods sold decreases.

Answer: (B)

Verified step by step guidance

1. Understand the concept of free cash flows: Free cash flows represent the cash available to a company after accounting for capital expenditures and working capital needs. It is a measure of financial flexibility and liquidity.
2. Analyze the relationship between inventory and cash flows: Inventory is considered a current asset, and purchasing inventory ties up cash. A decrease in inventory means less cash is tied up, potentially freeing up cash for other uses.
3. Consider the perpetual and periodic inventory systems: Both systems track inventory levels, but the perpetual system updates inventory continuously, while the periodic system updates inventory at specific intervals. Regardless of the system, a decrease in inventory affects cash flows similarly.
4. Evaluate the impact of a decrease in inventory: If inventory decreases, it implies fewer purchases or a reduction in stock levels. This results in less cash being spent on inventory, thereby increasing free cash flows.
5. Conclude the reasoning: Since less cash is tied up in inventory due to the decrease, free cash flows increase, assuming all other factors remain constant.