Investment Banking puzzles, solved step by step

Net income falls Rs 7.5, cash rises Rs 2.5, inventory falls Rs 10 and retained earnings fall Rs 7.5. The write-down is an expense, so pre-tax income falls 10 and, after the Rs 2.5 tax saving, net income falls 7.5. No cash left the business, so the cash flow statement adds the 10 back and cash ends Rs 2.5 higher. Assets fall 7.5 and equity falls 7.5, so it balances.

Why does a loss leave the company with more cash?

A shopkeeper finds a carton of biscuits past their date. They cost Rs 10 and are now worth nothing. No money changes hands today; the cash went out when the biscuits were bought. What changes is that the loss lowers this year's taxable profit. A write-down is a non-cash loss, so its only cash effect is the tax it saves, and cash rises by 25% of Rs 10. Inventory is carried at the lower of cost and net realisable valueWhat the stock can be sold for, less the costs of selling it., which is why the carrying amount is cut when goods lose value.

How does each statement move?

Income statement: the write-down usually sits inside cost of goods sold, so pre-tax income falls 10, tax falls 2.5 at 25%, and net income falls 7.5. Cash flow statement: start from net income of minus 7.5, add back the 10 because no cash left, and operating cash flow is plus 2.5. Balance sheet: inventory is down 10 and cash is up 2.5, so total assets are down 7.5, and retained earnings are down 7.5. The check is minus 10 plus 2.5 on the asset side equalling minus 7.5 in equity.

What assumption should you say out loud?

That the write-down is deductible for tax now, as the question states. Whether a tax system allows the deduction when the stock is written down or only when it is sold depends on its rules, which you would confirm. If the deduction comes later, cash does not move this year and the company records a deferred tax asset of Rs 2.5 instead, with the balance sheet still balancing. Offering that variant in one sentence shows you understand why the cash moved in the first place.

Only the balance sheet changes. Property, plant and equipment rises by Rs 100 crore and accounts payable rises by Rs 100 crore, so both sides grow by the same amount. No cash has moved, so the cash flow statement is untouched, and no time has passed for depreciation, so the income statement is untouched too. Cash and capex appear in 60 days, when the supplier is paid.

Why does a purchase on credit touch neither cash nor profit?

Think of buying a refrigerator on a shop's 60-day credit. The fridge is in your kitchen today and you owe the shop, but your bank balance has not moved and nothing has come out of this month's budget. A credit purchase adds an asset and a debt of the same size, so the balance sheet grows on both sides and nothing else moves. The machine will be used for years, so its cost is not an expense on the day it arrives. It reaches the income statement slowly, through depreciation, over the years it is used.

What happens over the next 60 days and beyond?

Day 60 is when the cash flow statement wakes up. The company pays the supplier: cash falls by 100 and payables fall by 100. The Rs 100 crore appears as capital expenditure in investing cash flow in the year it is paid, not the year the machine arrived. The notes to the accounts usually flag the year-end purchase as a non-cash investing item, so a reader is not surprised. From the following year, depreciation starts: on a 10-year straight line, Rs 10 crore a year comes off pre-tax profit, is added back in operating cash flow, and lowers the machine's book value.

Close by saying the balance check out loud. Assets up 100, liabilities up 100: the sheet balances, and that one sentence tells the interviewer you walk the statements in a fixed order rather than guessing. Interviewers use small timing questions like this one to see whether you separate when something is owned, when it is paid for and when it is expensed.

EBITDA is unchanged, net income falls by 50, cash is unchanged, and goodwill and equity both fall by 50. The impairment sits below EBITDA, so operating profit and pre-tax profit drop 50. Because it is not deductible, tax does not change and net income falls the full 50. The cash flow statement adds the non-cash charge back. On the balance sheet goodwill drops 50 and retained earnings drop 50.

What is an impairment actually admitting?

Suppose you paid Rs 10 lakh for a used car three years ago and a dealer now offers 6 lakh. Writing the car down in your notebook does not take money out of your wallet; the money left when you bought it. A goodwill impairment admits that an acquisition was overpaid for in the past; it does not spend any new cash. GoodwillThe part of an acquisition price above the fair value of the identifiable net assets bought, carried as an asset on the buyer balance sheet. is the premium paid above the target's net assets, and the write-down says part of that premium is no longer supported by the business's expected cash flows.

Why does net income fall the full 50 rather than 37.5?

Tax is what makes most non-cash charges reach cash. Depreciation, for example, usually cuts the tax bill, so a 50 charge at 25% lowers tax by 12.5. Goodwill impairment is generally not deductible, so the tax line does not move and the whole 50 hits net income. Confirm the rule in the relevant tax regime before relying on it. If the charge were deductible at 25%, net income would fall 37.5, cash would rise 12.5 from the lower tax bill, and the balance sheet would show cash up 12.5, goodwill down 50 and equity down 37.5.

Why does an analyst care if nothing happened to cash?

Because it tells you something about management's past decisions and future cash flows. An impairment says an acquisition is earning less than was paid for it, which usually reflects weaker expected cash flows. It also lowers book equity, which can push up leverage ratios measured on book values and occasionally trip a covenant. Most analysts strip it out of adjusted earnings as a one-off, but a string of them is a pattern worth asking about.