Financial Analysis puzzles, solved step by step

Net income rises Rs 7.5 crore, cash falls Rs 2.5 crore, and net fixed assets are Rs 10 crore higher. Income statement: depreciation down 10, pre-tax profit up 10, tax up 2.5, net income up 7.5. Cash flow: net income up 7.5 but the add-back down 10, so cash from operations down 2.5. Balance sheet: cash down 2.5, fixed assets up 10, assets up 7.5, matched by retained earnings up 7.5.

Why does profit rise while cash falls?

A shopkeeper who decides his delivery van will last ten years instead of five writes off half as much each year. The van is the same van, the fuel bill is the same, and no customer paid him more. Changing a useful life changes when the cost of an asset is recognised, not whether it is paid, so the extra profit is an accounting rearrangement with one real consequence: a higher tax bill. Depreciation falls 10, pre-tax profit rises 10, tax at 25% rises 2.5, and net income rises 7.5.

On the cash flow statement, start from net income, up 7.5, and add back depreciation, which is now 10 lower than before. Cash from operations is 7.5 - 10 = -2.5. Nothing changes in investing or financing, so cash falls 2.5. On the balance sheet, cash is down 2.5 and net fixed assets are up 10, because less accumulated depreciation has been charged against them: assets up 7.5. Retained earnings carry the 7.5 of extra net income, so liabilities and equity are also up 7.5.

Why is the higher profit not good news?

Because nothing about the business improved. The same machines wear out on the same schedule; the company will replace them on the same date for the same money; and it has handed Rs 2.5 crore to the tax authority earlier than it needed to. A profit increase that comes with a cash decrease and no operating change is cosmetic, and the choice to make it is itself a signal: management may be reaching for a target. It also breaks comparability with peers who kept the shorter lives, and the total charge over the asset's life is unchanged, so the profit that appears now is borrowed from later years.

What if tax depreciation did not follow book?

In practice the tax authority sets its own depreciation rates, and in India book depreciation under the Companies Act and tax depreciation under the Income Tax Act are computed separately; confirm the current rules before relying on this. Then cash tax does not change: net income still rises 7.5, but a deferred tax liabilityTax that the accounts recognise as owed on profit already reported, but that the tax return has not yet charged, so it will be paid in a later period. of 2.5 is booked instead of extra cash tax. On the cash flow statement, net income up 7.5, add-back down 10, deferred tax up 2.5: cash from operations is 0.0. The limit: in that version the change is purely cosmetic, cash untouched, which is why analysts read the depreciation policy note before they read the profit line.