Equity Research puzzles, solved step by step

Today: cash up Rs 50 crore, deferred revenue up Rs 50 crore, and no change to the income statement. Operating cash flow rises by 50 through the change in deferred revenue. On delivery, revenue of 50 and tax of 12.5 give net income of 37.5; deferred revenue falls by 50, so operating cash flow that year is minus 12.5, the tax paid, and equity rises 37.5.

Why is there no revenue on the day the cash arrives?

Think of a gym that sells a year's membership in January. The money is in the bank on day one, but the gym has not yet provided a single workout; if it shut down in February, it would owe most of that money back. Revenue is recorded when the service is delivered, so cash received in advance is a debt of service owed to the customer, and it sits on the balance sheet as deferred revenue.

On payment day the balance sheet grows on both sides: cash up 50 and deferred revenueCash received for goods or services not yet delivered. It is a liability until the company delivers, when it moves to revenue. up 50. The cash flow statement starts from net income of zero and adds the 50 rise in the liability, so operating cash flow is plus 50. The income statement is untouched.

What happens on the day the service is delivered?

Now the company has earned it. Revenue rises 50, tax at 25% is 12.5, net income rises 37.5. The cash flow statement starts at 37.5 and subtracts the 50 fall in deferred revenue, which leaves operating cash flow of minus 12.5: the profit was paid for in cash a year earlier, so the only cash that moves on delivery is the tax. The balance sheet balances: cash down 12.5 on one side, deferred revenue down 50 and retained earnings up 37.5 on the other.

For a research analyst this is the pattern behind subscription and advance-booking businesses: cash flow runs ahead of profit while bookings grow, and falls behind when they shrink. A growing deferred revenue balance flatters operating cash flow, so read the two together. The tax assumption matters too: some tax systems tax advances when received, so confirm the rule that applies before modelling it.

Working capital absorbed Rs 130 crore, more than all of the profit. Start at net income of 100 and add depreciation of 20. Receivables up 80 and inventory up 60 each tie up cash; payables up 10 frees some. Operating cash flow is minus 10. Capex of 20 takes the change in cash to minus 30, matching the fall.

How can a profitable company lose cash?

Think of a wholesaler who sells a lot this month, but on 90 days' credit, and stocks up for the festive season. The books show a profit, yet the bank balance falls, because the sales have not been collected and the new stock has been paid for. Profit counts sales when they are made; cash counts them when they are collected, and growing receivables and inventory are the gap between the two.

Which way does each working capital line push cash?

Read the balance sheet change and ask whether cash went out or came in. A rise in an asset such as receivables or inventory uses cash; a rise in a liability such as payables provides it. Receivables and inventory together took Rs 140 crore and payables returned Rs 10 crore, so working capital absorbed Rs 130 crore against Rs 120 crore of profit plus depreciation. That makes operating cash flow minus 10.

What a research analyst does next: compare the rise in receivables to sales growth. If receivables grew much faster than revenue, customers are paying more slowly or sales were pushed through on easy terms, and that is a question for management. The limitation: a fast-growing company can have this pattern for healthy reasons, so the answer needs the trend, not one year.

EPS and net worth fall; cash and net debt to EBITDA do not move. Assuming no tax deduction for the charge, reported profit falls by Rs 200 crore, taking EPS from Rs 5.00 to Rs 3.00 on 100 crore shares, and net worth falls by Rs 200 crore. No cash leaves, and EBITDA sits above the charge, so a covenant at 2.5x net debt to EBITDA is untouched. A covenant set on debt to equity would move.

Why does a Rs 200 crore loss leave cash untouched?

Imagine you paid Rs 20 lakh for a car three years ago and a valuer now says it is worth Rs 12 lakh. You are poorer on paper, but your bank balance did not change today; the money left when you bought it. A goodwill impairment admits that an acquisition was worth less than was paid, and the cash for that acquisition left the business when the deal closed. The goodwillThe part of an acquisition price above the fair value of the net assets bought, carried as an asset on the balance sheet. is written down, reported profit takes the charge and equity falls with it.

Which covenant does move, and why does the difference matter?

A covenant built on EBITDA is blind to the charge. A covenant built on net worth or on debt to equity is not: gross debt of Rs 1,300 crore against equity of Rs 2,000 crore is 0.65x, and after the write-down it is 0.72x. So the same accounting entry can be harmless under one loan and a breach under another. An analyst reads the covenant definitions before saying which.

Two more things to say. Most analysts strip the charge out of adjusted EPS, which stays at Rs 5.00, because it says nothing about next year's earnings. And whether the charge saves tax depends on local rules, which usually do not allow a deduction for goodwill impairment; confirm before assuming either way. The real signal is about management: the acquisition is now expected to earn less than was paid for it.

On day one nothing touches the income statement: equipment and debt each rise by Rs 100 crore, and cash flow shows minus 100 in investing and plus 100 in financing. A year later, depreciation of Rs 10 crore and interest of Rs 9 crore cut pre-tax profit by Rs 19 crore and net income by Rs 14.25 crore. Cash falls Rs 4.25 crore, equipment is Rs 90 crore, debt is still Rs 100 crore and equity is down Rs 14.25 crore.

Why does nothing hit profit on the day of purchase?

Buy a delivery van on the last evening of March with a bank loan and you are no poorer that night: you swapped borrowed money for a van. The costs come later, as the van wears out and as the loan collects interest. Buying an asset with borrowed money swaps one balance sheet item for another; costs reach the income statement only as the asset is used up and as time passes on the loan. So on day one the only movements are equipment up 100, debt up 100, and the cash flow statement showing the money coming in through financing and going out through investing.

How do the numbers flow through at the end of year one?

Start on the income statement. Depreciation is 100 / 10 = Rs 10 crore and interest is 9% of 100 = Rs 9 crore, so pre-tax profit falls Rs 19 crore. Tax falls by 25% of that, Rs 4.75 crore, so net income falls Rs 14.25 crore. On the cash flow statement, add back the Rs 10 crore of depreciation, which never left the bank: cash falls Rs 4.25 crore. The cash cost of the year is the interest less the tax it saves, 9 - 2.25 = 4.25; depreciation costs profit but not cash.

What assumptions should you say out loud?

Four of them. Interest is paid in cash at the end of the year. The tax saving is real because the company has other profits to set it against. Tax depreciation matches book depreciation. No principal is repaid in year one. Stating the assumptions turns a walkthrough into an argument the interviewer can follow, and each one is a lever for the next question. Change the second, and a loss-making company saves no tax this year, so net income falls the full Rs 19 crore.

About Rs 82 crore. Receivables were Rs 1,000 crore times 60 over 365, about Rs 164 crore. Now they are Rs 1,200 crore times 75 over 365, about Rs 247 crore. Of the Rs 82 crore increase, about Rs 33 crore is growth at the old terms and about Rs 49 crore is customers paying 15 days later. That cash comes straight out of operating cash flow.

How do receivable days turn into rupees?

A kirana store that lets customers settle at month end is carrying about a month of its own sales as money owed. Receivable daysReceivables divided by revenue, times 365: roughly how many days of sales customers owe at any time. work the same way: receivables are sales per day times the days customers take to pay. Rs 1,000 crore a year is about Rs 2.74 crore a day, and 60 days of that is Rs 164.4 crore. At Rs 1,200 crore and 75 days it is Rs 246.6 crore.

Why split the increase into two pieces?

Because the two pieces tell different stories. Growth at unchanged terms is the ordinary cost of selling more: Rs 32.9 crore. The extra 15 days is a change in behaviour, Rs 49.3 crore, and it is the piece an analyst asks management about. Customers might be under stress, the company might be offering longer credit to win sales, or revenue might be booked earlier than the cash warrants. Any of those makes reported growth lower quality.

Where does it show up in the statements?

The income statement books the full Rs 1,200 crore of revenue. The cash flow statement subtracts the Rs 82.2 crore rise in receivables from operating cash flow, because that revenue has not been collected. So profit grows while cash lags, which is the pattern behind the question of why a company's revenue is growing but its cash is not. The limit of the day count is seasonality: a year-end balance can mislead if sales are lumpy, so compare the same quarter across years.