Debt write-down: 3 financial statements treatment
This got me slightly confused to be honest friends.
So, in one of the guides it says that debt write down would increase pre tax income by the amount of write down (let’s assume $100). I suppose it would be reflected as a gain on income statement? The explanation says “the debt is written down reflects the fact that cash flow, that literally would have been directed towards paying that debt, has been freed up”. This got me confused because I don’t think the explanation is properly formulated.
My thinking was that how can we reflected freed up cash for debt repayment on the income statement if we aren’t reflecting debt repayments on income statement at all. So my initial thought was to just adjust the income statement to the savings on interest expense but obviously that way balance sheet did not add up and I understand that the former methodologies is correct mechanically, but can someone please give me a more logical rationale behind that? Merci!
Take a step back, think of it intuitively. The debt is a liability on the company's balance sheet, so a write-down of a liability should be a gain, just as inversely a write-down of an asset would be a loss.
Let’s say you have a factory worth 100 that you financed half with equity half with debt. Your balance sheet will reflect the fact that you have an asset worth 100, and your lenders have a 50 claim on those assets. The residual is equity worth 50.
Let’s say that your lenders by the grace of god forgive your debt. You know assets haven’t changed (nothing happened to the factory), but liabilities went down by 50. So you know that your residual claim is now worth 100 (for now let’s ignore tax effects).
Typically, but not always, gains in residual value flow through the income statement in some way, so you might record an item as a ‘gain on extinguishment of debt’ or something of that nature, which would increase net income (and ultimately flow through as an increase in retained earnings). So you’d show net income of 50.
You also know that this increase in net income is non cash, so you’d reverse out the gain on the cash flow statement to show that cash from operations is zero.
In an interview, you would be expected to understand how taxes affected the problem (which will sort of mirror how a typical depreciation question works), and you’d be expected to start your explanation from the income statement (I just think starting from the bs is more intuitive) so:
Savior.
Thanks for the explanation, this is very helpful. But isn't the debt write down financing related and hence should appear under cash from financing activities?
The write down isn’t cash, so it shouldn’t show up there. Think of it this way, its in net income, so unless we do something in cash from ops, then our cash from ops contains a non cash component.
Let's just remove taxes for simplicity purposes.
When we write down that debt, do we actually get any physical cash? No, we don't. So, if we don't get any cash whatsoever, then we should have a change of $0 on the CFS.
I think it helps to think about it from the BS perspective.
We are essentially reclassing $50 of Debt into Equity by way of Retained Earnings (assuming no taxes). Our cash balance in assets doesn't change, as we intuitively expected. So therefore, our CFS and CFFO should be $0. To get $0, we have to add back the $50 of debt extinguishment on the CFFO.
No, I don't think so. Sure, the statements balance but what Motley Accrual has written covers the 3-statements.
Think about it this way, this same question can be posed as a $10 increase (or decrease) in depreciation. Cash doesn't change hands and yet CFO is recognised to be $2 higher (lower). That's because these questions are implicitly asking about a comparison against the case where depreciation or debt had not moved. To see this, re-run the numbers above by Motley but this this time without any change in debt and then compare to the figures given by Motley (you can make up example EBITDA, tax figures and use a blank XLS to help visualise this).
Lastly, to make the final link - re-run Motley's elaboration above but with tax rate of 0%. You will see that everything effectively cancels out.
Connecting the two ideas above to close this out, it's basically the tax shield that "creates" cash when compared to the scenario in which such a change in depreciation or debt had not taken place.
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