Equity Research puzzles, solved step by step

Cash tax falls by Rs 3.75 crore, reported tax does not change, and the deferred tax liability rises by Rs 3.75 crore. Tax is paid on taxable profit, which uses the Rs 25 crore tax depreciation. The P&L charges tax on book profit, which uses Rs 10 crore. The Rs 15 crore gap at 25% is Rs 3.75 crore of tax postponed, not saved: it comes back when tax depreciation later falls below book.

Why can two depreciation numbers exist for the same machine?

Think of a salaried employee who is allowed to claim a deduction early in the year for an expense she will actually use over three years. Her tax bill falls now, but she cannot claim it again later. Tax rules often allow depreciation faster than the books show it, so the same asset produces a larger deduction early and a smaller one later. The total over the asset's life is the same; only the timing differs. Confirm the current depreciation rates in the tax rules before using real numbers.

Where does each number land in the three statements?

The income statement shows a tax expense of Rs 25.00 crore, split into current tax of Rs 21.25 crore and deferred tax of Rs 3.75 crore, so net income is Rs 75 crore either way. The cash flow statement adds back the Rs 3.75 crore of deferred tax as a non-cash charge, so operating cash flow is Rs 3.75 crore higher than it would be if both depreciation numbers matched. On the balance sheet the deferred tax liability rises by Rs 3.75 crore, matched by the extra cash.

The analyst's point: a growing company that keeps buying assets keeps adding new early-year gaps, so its deferred tax liability can grow for years and behave almost like permanent free funding. When capex slows, the reversals arrive and cash tax rises above reported tax. That is worth one sentence in the room.

EBITDA rises Rs 40 crore, EBIT rises Rs 30 crore, operating cash flow rises Rs 40 crore and investing cash flow falls Rs 40 crore; total cash does not change. Capitalising takes the spend off the income statement and puts Rs 10 crore of amortisation below EBITDA instead. On the cash flow statement the same Rs 40 crore moves from the operating section to the investing section. The company is no richer; it only looks richer on the two most quoted lines.

What does capitalising actually move?

A family that buys a Rs 40,000 laptop to last four years of college can tell itself it spent Rs 40,000 this month, or Rs 10,000 a year for four years. The bank balance is the same either way. Capitalising a cost is the second story: the money leaves in year one, but the income statement recognises it a quarter at a time. The spend becomes an asset on the balance sheet, and the cash paid for it is reported under investing activities instead of operating ones.

Which lines improve, and by how much?

Take a company with EBITDA of Rs 150 crore before this spend and nothing else going on. Expensed, EBITDA, EBIT and operating cash flow are all Rs 110 crore. Capitalised, EBITDA is Rs 150 crore, amortisation takes Rs 10 crore, EBIT is Rs 140 crore, operating cash flow is Rs 150 crore and investing cash flow is minus Rs 40 crore. EBITDA and operating cash flow each gain the full Rs 40 crore, EBIT gains only Rs 30 crore, and net cash is Rs 110 crore both ways.

What happens once tax is added?

It depends on the tax rules, which vary by country and should be confirmed for the case at hand. If the tax authority allows the deduction on the spend whatever the accounts say, cash tax is the same both ways, and book profit after a 25% tax is Rs 22.5 crore higher, with a Rs 7.5 crore deferred tax liability. If tax instead follows the books, capitalising raises year-one cash tax by Rs 7.5 crore, so the choice that flatters profit actually costs cash.

Why does an analyst care?

Because the two lines that gain are the two most used in valuation and quality screens: EV/EBITDA and cash conversion. A company that capitalises heavily looks cheaper on EV/EBITDA and converts more of its profit into operating cash than a peer that expenses the same spend. The fair comparison is free cash flow after all capital spending, including capitalised development, which is Rs 110 crore in both cases. If the spend recurs every year, amortisation builds to Rs 40 crore by year four and EBIT converges, but EBITDA stays Rs 40 crore higher for good.

EBITDA rises by the full Rs 12 crore, EBIT by about Rs 4.3 crore, net debt by a lease liability of about Rs 77 crore, and EV/EBITDA falls from 10.0x to 9.40x. Rent leaves operating costs and returns as depreciation of Rs 7.7 crore and interest of Rs 6.9 crore. The cash paid is identical, so the only safe comparison is between companies measured on the same basis.

Why does the rent move out of EBITDA at all?

Think of the difference between renting a flat and buying it with a home loan. The owner pays an EMI that is partly interest and partly repayment, and the flat sits on the family balance sheet as an asset with a loan against it. The lease standard treats a long lease the same way: the right to use the store becomes an asset, the promise to pay rent becomes a debt, and the rent itself disappears from operating costs. Discount ten payments of Rs 12 crore at an assumed borrowing rate of 9% and the lease liabilityThe present value of the lease payments still to be made, carried on the balance sheet like a loan. is Rs 77.0 crore.

What replaces the rent in the income statement?

Two lines, both below EBITDA. The right-of-use assetThe asset recognised for the right to use a leased item, depreciated over the lease term. of Rs 77.0 crore is depreciated over ten years, Rs 7.7 crore a year, and the liability accrues interest at 9%, Rs 6.9 crore in year one. So EBITDA gains the whole Rs 12 crore, EBIT gains only Rs 4.3 crore, and year-one pre-tax profit actually falls by Rs 2.6 crore, because interest is heaviest while the liability is largest. Over the ten years the charges add up to Rs 120 crore, the same as the rent; only the timing moves.

Why does this matter when you compare two retailers?

Because the multiple now depends on whether a company rents or owns its stores. A retailer that leases every store will look cheaper on EV/EBITDA and more levered on net debt to EBITDA than an identical one that owns its stores, unless you put both on the same basis. Here leverage rises from 3.33x to 3.85x while the multiple falls. Say which basis you are using, and either include leases for everyone or strip them out for everyone. The standard's exemptions for short-term and low-value leases also vary in use, so check the notes before comparing.