Financial Analysis puzzles, solved step by step
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042A company sells land with a book value of Rs 40 crore for Rs 100 crore and pays 20% tax on the gain. Walk it through the three statements, and explain why the gain is subtracted in cash from operations.Big FourCorporate FP&A
Try it first
What does cash from operations show for this transaction?
Show the worked solution
Net income rises Rs 48 crore, cash rises Rs 88 crore, and the balance sheet balances at plus Rs 48 crore. The gain of Rs 60 crore less Rs 12 crore tax gives net income of Rs 48 crore. Cash from operations starts at 48 and subtracts the Rs 60 crore gain, leaving minus 12; investing shows the full Rs 100 crore. Cash is up Rs 88 crore, land down Rs 40 crore.
Why subtract a gain you actually made?
Think of selling your old scooter for Rs 50,000 when you had it on your books at Rs 20,000. You did receive Rs 50,000 in cash, all of it, on the day of the sale. If your diary records a Rs 30,000 profit under daily earnings and also Rs 50,000 under scooter sold, you have counted Rs 30,000 twice. The cash flow statement puts the full sale proceeds in investing, so the gain sitting inside net income has to be taken out of operations, or part of the sale would be counted twice.
Cash from operations starts at net income of Rs 48 crore and backs out the Rs 60 crore gain, leaving minus Rs 12 crore of tax, while investing carries the full Rs 100 crore of proceeds, so cash rises Rs 88 crore and the balance sheet balances at plus Rs 48 crore. How does each statement move, line by line?
Income statement: a gain on sale of Rs 60 crore, tax of 20% on it, Rs 12 crore, so net income is up Rs 48 crore. Cash flow statement: start from net income of 48, subtract the non-operating gain of 60, and cash from operations is minus 12; investing shows plus 100; cash is up 88. Balance sheet: cash up 88, land down 40, so assets are up 48; retained earnings up 48. The check that matters is that the change in assets equals the change in equity, Rs 48 crore each side.
State the assumption: the tax is paid in cash in the same year. If it were deferred, operations would show zero, a tax liability would sit on the balance sheet and cash would be up the full Rs 100 crore. Say also why the tax stays in operations: accounting rules generally classify income taxes as operating unless they are specifically tied to an investing activity, and practice varies, so confirm the treatment the company uses.
Where candidates lose it
The trap is putting the Rs 100 crore in operations, or putting it in investing and forgetting to back out the gain. The second version leaves cash up Rs 148 crore, and the balance sheet will not balance.
Candidates also put the gain on the cash flow statement as an add-back, the way they treat depreciation. Depreciation is a non-cash expense, so it is added back. A gain is a non-operating income, so it is subtracted. Say which one it is before you pick the sign.
What the interviewer asks next
- What changes if the land is sold for Rs 30 crore, a loss?
- How would the answer change if the tax is deferred to next year?
- Where would the sale of a machine at book value show up?
085A company writes off Rs 20 crore of obsolete inventory in full, at a 25% tax rate. Walk the three statements. Then, next year, the same stock is sold for scrap at Rs 5 crore: what happens to that year's gross margin, and why?Big FourCorporate FP&A
Try it first
In the year of the write-down, what happens to cash from operations?
Show the worked solution
Year one: profit falls Rs 15 crore, inventory falls Rs 20 crore, cash rises Rs 5 crore from tax saved. Year two: gross margin is flattered. The scrapped stock sits on the books at zero, so the Rs 5 crore sale is pure gross profit, lifting margin from 30.0% to 30.9% on these figures. The write-down moved profit between years, because it wrote off more than the stock turned out to be worth.
How does a write-down move through the three statements?
Suppose you bought Rs 20,000 of winter jackets for your shop two years ago, and they are now unsellable. Admitting it does not take any money out of your till today; the money left when you bought them. An inventory write-down is a non-cash expense that recognises a loss of value already suffered, so its only cash effect is the tax it saves.
Statement Line Year 1, Rs crore Income statement Cost of goods sold (write-down) +20.0 Income statement Tax at 25% -5.0 Income statement Net income -15.0 Cash flow Net income -15.0 Cash flow Add back non-cash write-down +20.0 Cash flow Cash from operations +5.0 Balance sheet Inventory -20.0 Balance sheet Cash +5.0 Balance sheet Retained earnings -15.0 Year one: assets fall Rs 15 crore (inventory -20, cash +5) and equity falls Rs 15 crore, so the balance sheet balances. Assumes the write-down is tax deductible when booked; confirm the rule in your jurisdiction. Check the balance sheet: assets are down Rs 15 crore, Rs 20 crore of stock gone and Rs 5 crore of cash added, and retained earnings are down by the same Rs 15 crore. It balances, which is the test an interviewer listens for.
Why does next year's gross margin look better than normal?
The stock now has a book value of zero. When it is sold for Rs 5 crore, revenue rises Rs 5 crore and cost of goods sold rises by nothing, because there is no cost left to expense. On a normal Rs 400 crore of sales at 30%, the write-down year shows 25.0% and the scrap year 30.9%. Writing down more than the stock is finally worth pulls a loss into this year and pushes an equal gain into the next.
Gross margin drops to 25.0% in the write-down year and rises to 30.9% when the zero-value stock sells for scrap, while across both years profit after tax totals minus Rs 11.25 crore, exactly the true loss after tax. Over both years nothing is lost or gained by the timing. Pre-tax, the total is minus Rs 20 crore plus Rs 5 crore, or minus Rs 15 crore: the true economic loss on stock that cost Rs 20 crore and fetched Rs 5 crore. Accounting rules generally require inventory to be carried at the lower of cost and net realisable value. If the company expected Rs 5 crore of scrap value, the honest write-down was Rs 15 crore, and the sale would have produced no gain at all.
What does an analyst do with this?
Treat both effects as one event. Strip the write-down out of year one's gross margin and the scrap gain out of year two's, and you see the business's real run-rate margin of 30%. A large write-down followed by margins above the old normal is a pattern worth asking management about, because over-provisioning creates a reserve that can be released into later profits. That is not proof of anything; obsolete stock genuinely varies in what it fetches. It is a question to ask.
Where candidates lose it
The common error is saying cash falls by Rs 20 crore, or by Rs 15 crore, in the write-down year. The cash left when the stock was bought. The write-down is added back on the cash flow statement, and the only cash effect is the Rs 5 crore of tax saved.
The second loss is missing the follow-on. Candidates walk year one cleanly and then say the scrap sale is 'just revenue'. It is revenue with no cost attached, because the cost was already expensed, and that is why the margin jumps. Connecting the two years is the point of the question.
What the interviewer asks next
- How would the answer change if the tax authority allowed the deduction only when the stock is actually disposed of?
- Where in the accounts would you look to see how large the inventory provision is and how it moved?
- Walk the three statements if instead the stock is sold for Rs 25 crore.