Financial Analysis puzzles, solved step by step

Without a provision, net income falls Rs 37.5 lakh; with a full provision already booked, it does not move. With no provision, the Rs 50 lakh is an expense, tax falls Rs 12.5 lakh, and net income falls 37.5. Cash rises 12.5 from lower tax, receivables fall 50 and retained earnings fall 37.5. With a provision booked last year, the write-off only removes the debt and the provision together, so profit and cash are unchanged.

What happens when nothing was set aside?

Think of a shopkeeper with a customer who has run up a tab and then left town. The money was counted as owed; now it never will be. Writing off a debt with no provision turns an asset into an expense in one step: receivables fall Rs 50 lakh and a bad debt expense of Rs 50 lakh hits profit. Assuming the write-off is tax deductible, tax falls Rs 12.5 lakh, so net income falls Rs 37.5 lakh. On the cash flow statement, add back the Rs 50 lakh because no cash moved; cash from operations rises Rs 12.5 lakh, the tax saved. The balance sheet balances: assets fall 37.5 (receivables down 50, cash up 12.5) and retained earnings fall 37.5.

Why does the provision case show nothing this year?

Because the loss was already recognised. A provision for doubtful debtsAn amount set aside against receivables the company expects not to collect. It reduces net receivables on the balance sheet and is charged to profit when it is created. is booked when a loss becomes likely, and that is when profit takes the hit. Accounting recognises a loss when it becomes probable, not when the customer finally fails, so the write-off later is a tidy-up between two balance sheet lines. Gross receivables fall Rs 50 lakh, the provision against them falls Rs 50 lakh, and net receivables are unchanged. Under Ind AS 109 and IFRS 9 companies provide for expected credit losses in advance, which is this logic applied to a whole loan book.

What about tax in the provision case?

This is the follow-up that separates good answers. In many tax systems a general provision is not deductible until the debt is actually written off, so the tax saving arrives now even though the expense was booked last year. The books handle that with a deferred tax asset created last year and reversed this year: cash tax falls Rs 12.5 lakh now, with no effect on this year's profit. Treat the rule as something to confirm for the jurisdiction where the company files tax, rather than a fixed fact.

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.

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.

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.

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.

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.

Basic EPS is Rs 30.0; diluted EPS is Rs 26.88, about 10% lower. The if-converted method assumes conversion: add back the after-tax interest saved, Rs 30 crore x 0.75 = Rs 22.5 crore, and add 2 crore shares. That gives Rs 322.5 crore over 12 crore shares. On actual conversion, debt falls Rs 500 crore and equity rises Rs 500 crore, interest expense stops, and no cash changes hands.

What does the if-converted method assume?

Imagine a friend lent your shop Rs 5 lakh and can choose, any time, to swap the loan for a share of the business. To be honest with your other partners about what each share is worth, you would show the numbers as if the friend has already swapped: no more interest to pay, but one more partner splitting the profit. Diluted EPS shows earnings per share as if every convertible security that would reduce EPS had already converted, adding back the interest it would save and adding the shares it would create.

The interest is Rs 500 crore x 6% = Rs 30 crore a year. It was tax-deductible, so removing it raises net income by only Rs 30 crore x (1 minus 25%) = Rs 22.5 crore. Conversion creates Rs 500 crore / Rs 250 = 2 crore shares. Diluted EPS is (300 + 22.5) / (10 + 2) = Rs 26.875, which rounds to Rs 26.88.

How do you know whether a convertible dilutes?

Compare what each new share brings with what each existing share earns. Each conversion share brings Rs 22.5 crore / 2 crore = Rs 11.25 of earnings, far below basic EPS of Rs 30, so including the convertible lowers EPS and it must be counted. If basic EPS were below Rs 11.25, conversion would raise EPS; that security is anti-dilutive and is left out of diluted EPS. The test is per security, so a company with several convertibles ranks them from most to least dilutive.

What happens to each statement on actual conversion?

Balance sheet: borrowings fall Rs 500 crore and equity rises Rs 500 crore, split between share capital at face value and securities premium. Total assets do not move; the right-hand side changes its mix and leverage falls sharply. Income statement: from the conversion date, the Rs 30 crore of interest stops, so profit rises Rs 22.5 crore after tax. Cash flow statement: nothing at conversion, because no cash changes hands; it is disclosed as a non-cash transaction. Afterwards, the Rs 30 crore of cash interest is no longer paid. Reported basic EPS after conversion should land close to the diluted EPS already shown, which is why analysts value on the diluted figure.