Equity Research puzzles, solved step by step
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050Depreciation expense rises by Rs 10 crore and the tax rate is 25%. Walk the change through the income statement, the cash flow statement and the balance sheet.Millennium ManagementNew York · 2024
Try it first
What happens to cash?
Show the worked solution
Net income falls Rs 7.5 crore, cash rises Rs 2.5 crore, PP&E falls Rs 10 crore and equity falls Rs 7.5 crore. Pre-tax profit drops Rs 10 crore and tax drops Rs 2.5 crore, so net income is down Rs 7.5 crore. The cash flow statement adds back the Rs 10 crore of depreciation, so cash is up Rs 2.5 crore. Assets fall Rs 7.5 crore net, matching the fall in retained earnings.
Why does a non-cash expense raise cash?
A shopkeeper who can deduct the wear on her delivery van from her taxable income pays less tax, even though no money went out for the wear itself. Depreciation moves no cash, but it is deductible, so it cuts the tax bill, and the tax saved is real cash: 25% of Rs 10 crore, Rs 2.5 crore. That is the one cash effect in the whole question; everything else is accounting.
Rs 10 crore of extra depreciation cuts net income by Rs 7.5 crore, the add-back turns that into a Rs 2.5 crore rise in cash, and on the balance sheet cash up 2.5 and PP&E down 10 leave assets down 7.5, matching equity, because a non-cash expense raises cash by the tax it saves. How do you say it in the room in thirty seconds?
Go statement by statement, in the order the numbers flow. Income statement: pre-tax profit down 10, tax down 2.5, net income down 7.5. Cash flow: start at minus 7.5, add back 10, cash up 2.5. Balance sheet: cash up 2.5, PP&E down 10, assets down 7.5; equity down 7.5 through retained earnings; it balances. End on the balance, because that is the check the interviewer is waiting for.
Statement Line Change, Rs crore Income statement Pre-tax profit -10.0 Income statement Tax -2.5 Income statement Net income -7.5 Cash flow Operating cash flow +2.5 Balance sheet Cash / PP&E +2.5 / -10.0 Balance sheet Retained earnings -7.5 Every line follows from two facts: depreciation is deductible at 25%, and it moves no cash. Say the assumption: the tax return uses the same depreciation as the books. If the higher charge is only in the books, cash tax does not fall, the Rs 2.5 crore goes to a deferred tax asset instead, and cash does not move at all.
Where candidates lose it
The two classic slips are saying cash does not change because depreciation is non-cash, and letting net income fall the full Rs 10 crore by forgetting tax. Both come from rushing the first line.
The quieter loss is not closing the balance sheet. Candidates who say assets fall Rs 10 crore then cannot match equity. Cash up 2.5 is the piece that makes it balance.
What the interviewer asks next
- Now walk through a Rs 10 crore rise in inventory funded by cash.
- What if the extra depreciation is not deductible for tax?
- How does the change affect EBITDA and free cash flow?
Asked at Millennium Management, Investment Research, New York, 2024 (Wall Street Oasis):
Nothing as much, technical questions were super basic like $10 depreciation
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?Sell-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 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?
