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  1. 093A company's depreciation rises by Rs 10 crore and the tax rate is 25%. Walk the change through the income statement, the cash flow statement and the balance sheet.Credit risk arithmeticCoreMoody'sNew York · 2022

    Try it first

    What happens to the company's cash?

    Show the worked solution

    Net income falls Rs 7.5 crore, cash rises Rs 2.5 crore, and both sides of the balance sheet fall Rs 7.5 crore. Pre-tax profit drops 10, tax drops 2.5, so net income drops 7.5. The cash flow statement adds back the non-cash 10, leaving cash up 2.5. On the balance sheet, cash is up 2.5 and fixed assets down 10, total assets down 7.5, matched by retained earnings down 7.5.

    How does a non-cash charge put cash in the bank?

    Think of a shopkeeper who can deduct the wear on his delivery van from his taxable income. Writing the van down costs him nothing today, since he paid for it years ago, but it lowers the tax bill he pays this year. Depreciation moves no cash itself; the only cash effect is the tax it saves, 25% of Rs 10 crore, Rs 2.5 crore. That tax shield is the whole answer on cash, and the three statements are the bookkeeping that proves it.

    A Rs 10 crore non-cash charge leaves the company Rs 2.5 crore richer in cashIncome statementDepreciation+10.0Pre-tax profit-10.0Tax at 25%-2.5Net income-7.5Cash flow statementNet income-7.5Add back depreciation+10.0(non-cash charge)Cash from operations+2.5Balance sheetCash+2.5Fixed assets-10.0Total assets-7.5Retained earnings-7.5Both sides-7.5Net income flows to the cash flow statement and to retained earnings; the cash change flows to the balance sheet.The cash gain is the tax saved: 25% x 10 = 2.5.
    Extra depreciation of Rs 10 crore cuts net income by Rs 7.5 crore after a Rs 2.5 crore tax saving, the add-back leaves cash from operations up Rs 2.5 crore, and the balance sheet shows cash up 2.5 and fixed assets down 10, total assets down 7.5, matched by retained earnings down 7.5.

    What order do you walk it in?

    Income statement first, because everything starts from net income. Then the cash flow statement: net income down 7.5, add back the 10 of depreciation because no cash left, and cash from operations is up 2.5. Finish on the balance sheet and prove it balances: assets fall by 10 of fixed assets less 2.5 of extra cash, 7.5, and equity falls by the 7.5 of lower retained earnings. Stating that both sides moved by the same 7.5 is the check the interviewer is waiting for.

    The relationship
    ΔNI=−10(1−0.25)=−7.5ΔCash=−7.5+10=+2.5\Delta NI = -10(1 - 0.25) = -7.5 \qquad \Delta \text{Cash} = -7.5 + 10 = +2.5
    Delta NIchange in net income
    0.25tax rate
    +10the depreciation added back because no cash was spent
    What it says in wordsNet income falls by the after-tax charge, and cash rises by the tax the charge saved.

    Why does a credit analyst care?

    Because a lender is repaid in cash, not in profit. A company whose earnings fall because of higher depreciation may be generating slightly more cash, so interest cover measured on net income and on cash flow can move in opposite directions. The limit: the tax saving is real only if the company is paying tax; a loss-making company gets no cash benefit this year, and a higher depreciation charge often reflects heavy past capital spending that the analyst should look at directly.

    Where candidates lose it

    The usual slip is saying cash is unchanged because depreciation is non-cash, which forgets the tax line. The second most common is cash down 7.5, following net income and forgetting the add-back.

    The other loss is not closing the balance sheet. Say the two sides out loud, assets down 7.5 and equity down 7.5, so the interviewer hears that it balances.

    What the interviewer asks next

    • Walk through the same change if the company is loss-making and pays no tax.
    • Now the company buys Rs 50 crore of equipment with cash. Walk the three statements.
    • Why might a rating agency look at EBITDA rather than net income for this company?

    Asked at Moody's, Generalist, New York, 2022 (Wall Street Oasis): how the 3 statements are related / connected.