Investment Banking puzzles, solved step by step

About Rs 54 crore. Receivables today are Rs 730 crore times 45 over 365, which is Rs 90 crore. Next year revenue is Rs 876 crore and collection takes 60 days, so receivables are Rs 144 crore. The increase of Rs 54 crore is cash the business has earned but not collected. Rs 18 crore of it comes from growth and Rs 36 crore from slower collection, twice as much.

Why does growth eat cash at all?

Think of a tailor who lets regular customers pay a month and a half after collecting their clothes. If the business grows, more money is out with customers at any moment, even though nobody is paying late. Receivables are revenue earned but not yet collected, so when revenue grows at the same collection period the balance grows with it, and the increase is cash the business has to fund. Here 20% more revenue at 45 days lifts receivables from Rs 90 crore to Rs 108 crore.

How do you split the Rs 54 crore?

Take the two changes one at a time. Growth first: Rs 876 crore at the old 45 days is Rs 108 crore, so growth absorbs Rs 18 crore. Then slower collection: going from 45 to 60 days on Rs 876 crore adds 15 days of sales, Rs 36 crore. Fifteen extra days of collection on the larger business costs twice as much cash as 20% growth. The line to watch is days sales outstandingReceivables divided by revenue, times 365: the average number of days customers take to pay..

Does the order of the split matter?

A little. Slower collection first, on today's revenue, costs Rs 30 crore, and growth then adds Rs 24 crore; the Rs 6 crore difference is growth and slower collection compounding each other. The total is Rs 54 crore whichever way you split it, and slower collection is the bigger cause either way. Say which order you used. Then say what it means: a business growing fast while collecting slowly can report rising profit and falling cash at the same time, which is the pattern a lender looks for first.

Capitalising makes EBITDA 50 higher and net income 30 higher, but free cash flow is identical. Expensed, the 50 hits EBITDA and net income falls 37.5 after tax. Capitalised, only 10 of amortisation hits profit, so net income falls 7.5, and the 50 moves into investing cash flow as capex. Operating cash flow is 50 higher, capex 50 higher, and free cash flow is minus 37.5 under both.

If the same cash goes out, what actually changes?

Buying a laptop for work: you can think of it as this month's expense, or as a tool that lasts five years and costs a fifth each year. Your bank balance falls by the full price either way. Capitalising versus expensing changes which profit lines carry the cost and which cash flow section shows the outflow; it does not change the cash that left. That is why analysts compare companies on free cash flow when accounting choices differ.

Expensed: EBITDA falls 50, tax falls 12.5, net income falls 37.5. Capitalised: EBITDA is untouched, the year's amortisation is 50 over 5, which is 10, and net income falls 7.5. So capitalising shows EBITDA 50 higher and net income 30 higher in year one. In operating cash flow the capitalised company shows +12.5 against -37.5, a 50 swing, but it also shows 50 of capex in investing.

What assumption is doing the work on tax?

The question says the spend is deductible in year one either way, so the cash tax saving is 12.5 under both. In the capitalised books, tax expense follows the smaller 10 charge, and the 10.0 difference becomes a deferred tax liabilityTax that the accounts recognise as owed later because taxable profit was lower than book profit this year. that is added back in operating cash flow. If the tax authority instead required capitalisation too, the cash tax saving would fall to 2.5 and free cash flow under capitalisation would be -47.5, 10 lower: tax timing is the only route by which the choice reaches cash. State which rule you are assuming.

Why bankers care: two otherwise identical software companies, one capitalising development and one expensing it, will show different EBITDA margins. Valuing both on EV/EBITDA without adjusting flatters the one that capitalises. Look at capitalised development in the cash flow statement and either add it back to the expensing peer or deduct it from the capitalising one.