Operating Cash Taxes

Operational Taxes and Payment Timing

The amount of tax arising from operations is one matter, and the timing of its payment is another. Additionally, in some cases, the tax figure is driven by purely accounting operations rather than actual cash flows.

In a separate entry, I have demonstrated how to derive the effective tax from the statutory tax and how to transition from the effective tax to the operational tax. However, to make more reliable forecasts, an additional step is necessary, involving the analysis of deferred tax assets and liabilities.

Sometimes, tax assets and liabilities are presented in financial statements, while other times, clarifications need to be sought in the notes. Often, this is a time-consuming and complex process, so many opt not to undertake it and simply rely on the operational tax rate.

Additionally, calculating the cash tax rate is more relevant when an organization consistently defers taxes or pays them earlier. Otherwise, if the organization is in a growth phase, due to the significant variability in the rate, it is better to use the operational rate.

In the left table, using Walmart as an example, the list of tax assets and liabilities is provided. Such assets and liabilities can be generated by historical losses, employee stock options, certain types of income, operating leases, acquisitions of intangible assets, accelerated depreciation, etc. All these depend on the specific details of the tax legislation of the country.

Steps to Determine the Cash Tax Rate and Necessary Financial Statement Adjustments for Organization Evaluation:

1. Compile a Complete List of Tax Assets and Liabilities:
   • Segregate the operational and non-operational parts and create a new reorganized table (first right table). This reorganization is necessary for subsequent changes to be reflected in the reorganized balance sheet.
2. Adjust the Operational Rate:
   • Deduct/add the total effect of deferred operational tax assets and liabilities from the operational rate. The resulting absolute figure should be compared to EBITA (first lower right table).
3. Reflect These Assets and Liabilities in the Reorganized Balance Sheet:
   • In the reorganized balance sheet, items are categorized by invested operational assets, non-operational assets, and sources of funding.
   • The reduction in operational assets should be offset by the corresponding tax liability item for the intangible asset, which is a pure accounting addition arising at the moment of asset recognition due to mergers, as its future amortization expense is non-deductible for tax purposes.
   • A tax asset derived from historical losses should be added to non-operational assets, as this is a historical result unrelated to future operations.
   • The remaining portion of tax assets and liabilities should be aggregated in the sources of funding, equivalent to equity (since these liabilities impact retained earnings through the tax rate).

This detailed approach ensures a more accurate reflection of the financial position and performance, providing a clearer understanding of the impact of tax deferrals on cash flows and operational outcomes.

Source:
#VALUATION – Measuring and Managing the Value of Companies, 7th Edition
McKinsey & Company,
Tim Koller, Marc Goedhart, David Wessels

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