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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.