Net Operating Losses (NOLs) on the 3 Financial Statements (18:20)

There’s A LOT of confusion over how Net Operating Losses (NOLs) and Deferred Tax Assets (DTAs) work on the 3 financial statements.

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Net Operating Losses (NOLs) on the 3 Financial Statements (18:20)

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Net Operating Losses – How They Get Created and Used Up

Idea: If a company has lost money (negative Pre-Tax Income) in prior years, it can reduce its future Taxable Income with these losses (“carry-forwards”), or even receive refunds for some of its past taxes (“carry-backs”).

It’s easier to explain carry-forwards, so that’s what we’ll focus on here (plus, it’s a far more common interview question and on-the-job modeling task).

KEY CONCEPTS:

1. You do NOT adjust the Income Taxes shown on the Income Statement for anything related to NOLs – you make these adjustments separately and show the cash impact on the CFS.

2. The NOL itself does not appear on the Balance Sheet – only the tax savings it corresponds to show up there, within the Deferred Tax Asset (DTA) line item.

Example: A company has many years of prior losses accumulated in its Net Operating Loss (NOL) balance, but it suddenly turns profitable and starts recording positive Pre-Tax Income… sometimes.

Scenario 1: The company earns $100 in Pre-Tax Income, and has an initial NOL balance of $175.

In This Case: The company applies $100 of its NOL balance to offset its Pre-Tax Income and reduce its Taxable Income to $0.
It therefore pays $0 in true cash taxes. Its DTA decreases by the tax rate of 40% * $100, or $40.

On the Income Statement, nothing changes because taxes are recorded as-is. So the company’s Net Income is simply $60, or $100 of Pre-Tax Income minus $40 of Taxes.

On the Cash Flow Statement, the DTA decreasing by $40 causes cash flow to increase by $40. So at the bottom, cash is up by $100 due to $60 of Net Income and the $40 decrease in the DTA.

On the Balance Sheet, cash is up by $100, the DTA is down by $40, so the Assets side is up by $60. On the other side, Retained Earnings is up by $60 due to the Net Income of $60, so both sides balance.

Scenario 2: The company records a $200 Pre-Tax Income loss, and has an initial NOL balance of $75 from the previous step.

In This Case: The company’s NOL balance increases by $200. It pays $0 in cash taxes. Its DTA increases by $200 * 40%, or $80.

On the Income Statement, Net Income is simply negative $120 (negative $200 of Pre-Tax Income, minus negative taxes of $80).

On the Cash Flow Statement, Net Income is negative $120, and the DTA increasing by $80 reduces cash flow by $80. So cash is down by $200 at the bottom.

On the Balance Sheet, cash is down by $200, the DTA is up by $80, so the Assets side is down by $120.

On the other side, Retained Earnings is down by $120 due to the Net Income of negative $120, so both sides balance.

Scenario 3: The company earns $300 in Pre-Tax Income, and has an initial NOL balance of $275 from the previous step.

In This Case: The company applies $275 of its NOL balance to offset its Pre-Tax Income, and reduce its Taxable Income to $25.

It therefore pays $10 in true cash taxes ($25 * 40%). Its DTA decreases by 40% * $275, or $110.

On the Income Statement, nothing changes. So the company’s Net Income is simply $180, or $300 of Pre-Tax Income minus $120 of Taxes.

On the Cash Flow Statement, the DTA decreasing by $110 causes cash flow to increase by $110. So at the bottom, cash is up by $290 due to $180 of Net Income and the $110 decrease in the DTA.

On the Balance Sheet, cash is up by $290, the DTA is down by $110, so the Assets side is up by $180. On the other side, Retained Earnings is up by $180 due to the Net Income of $180, so both sides balance.

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