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  1. 075A company writes Rs 20 crore of inventory down to zero. The tax rate is 25% and the write-down is deductible for tax this year. What happens on each of the three statements?Three statement riddlesWarm upSell-side equity researchIndian brokerage research

    Try it first

    What happens to cash, counting the tax saving?

    Show the worked solution

    Net income falls Rs 15 crore and cash rises Rs 5 crore; inventory falls Rs 20 crore while equity falls Rs 15 crore. The write-down is a Rs 20 crore expense, cut to Rs 15 crore after the Rs 5 crore tax saving. It costs no cash today, so the cash flow statement adds the Rs 20 crore back, leaving cash up by the tax saved. Assets fall Rs 15 crore, and so does equity.

    Why does a Rs 20 crore loss raise cash?

    A shopkeeper who bought stock last year and finds this year that it has spoiled is not paying for it again; the money went out when the goods came in. Admitting the loss costs nothing new, and if the tax rules let her deduct it, she pays less tax this year. The cash for inventory leaves when it is bought; the write-down only records the loss, and the tax deduction is the one real cash effect today. So profit falls by the loss after tax, while cash rises by the tax saved.

    The write-down hits profit in full, but cash only through the tax it savesIncome statementWrite-down-20Tax saved at 25%+5Net income-15Cash flow statementNet income-15Add back write-down+20Change in cash+5Balance sheetCash+5Inventory-20Equity (retained)-15net income of -15 lowers retained earningsAssets: +5 cash - 20 inventory = -15Equity: -15. It balances.
    The Rs 20 crore write-down cuts net income by Rs 15 crore after tax, the cash flow statement adds the non-cash Rs 20 crore back to leave cash up Rs 5 crore, and the balance sheet balances with assets and equity both down Rs 15 crore.

    How do you walk it through the statements in order?

    Income statement first: a Rs 20 crore expense, usually inside cost of goods sold, lowers pre-tax profit by 20; tax falls by 25% of that, Rs 5 crore; net income falls Rs 15 crore. Cash flow statement next: start from net income of minus 15 and add back the Rs 20 crore, because no cash left; cash is up Rs 5 crore. Balance sheet last: cash up 5 and inventory down 20 take assets down 15, and retained earnings fall by the same 15, so the two sides move together.

    What if the tax rules are different?

    Tax treatment of write-downs varies by jurisdiction, and some rules allow the deduction only when goods are actually scrapped or sold, so confirm it for the case at hand. If the deduction comes later, book net income still falls Rs 15 crore, but cash tax does not change this year, so cash is flat and a Rs 5 crore deferred tax asset appears on the balance sheet instead. Saying this without being asked shows you know where the Rs 5 crore of cash came from.

    What does an analyst read into a write-down?

    Two things. The charge is usually treated as one-off, so analysts look at profit before it, but repeated write-downs say something about how the company buys and forecasts demand. A write-down also moves cost out of future periods: goods written off now cannot be expensed again when sold, so next year's gross margin can look better than the business really is.

    Where candidates lose it

    The common slip is saying cash falls by Rs 20 crore, as if the write-down were a payment. The money left when the goods were bought; today's write-down only admits the loss.

    The second slip is forgetting tax, which leaves net income down 20 and cash unchanged. With a deductible loss the tax saving is the only cash that moves, and it moves the other way: up Rs 5 crore.

    What the interviewer asks next

    • What changes if the write-down is not deductible for tax until the goods are scrapped?
    • Next year the written-off goods are sold for Rs 4 crore. What happens on the statements?
    • Why might a new management team write down inventory heavily in its first year?